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Sunday, July 8, 2012

Neither Grexit, Nor Spexit, It's Fixit or Fexit

The aftermath to last weeks EU summit has certainly proved to be a damn sight more perplexing than the actual summit itself. Contrary to earlier experiences, this time round the more the details have been "clarified" the more confused we have become.

Just what exactly was approved? Will Spain's banks really obtain capital directly from the ESM, and if so, how and when? Is Spain about to get a full bailout? Is Italy? Is there a commitment to bringing down sovereign borrowing costs. And just to top it all of what about Greece, what is the next move, is there any kind of plan?

Little wonder then that Spain's 10 year bond yields were once more back over 7% on Friday. Markets had taken the view that while agreement on the details of an ESM bond buying formula and full banking union would obviously take time, surely the ECB would be prepared to do something - another LTRO, reopen the Security Markets Programme - in the meantime. But no, Mario (Draghi this time) was not for turning, and sent the ball straight back into the politicians court.

Really I think the markets have gotten a bit ahead of themselves here in expecting instant action, since European decision making works according to its own timeless laws. To reach my conclusions before I draw them, I think it is plain that Spain's bank recapitalisation will be, kicking and screaming, an all Euro Group affair. That is to say the debt sharing the Finnish Finance Minister so desparately fears will take place, even if we take a while to get there. And Spanish and Italian bonds will be bought, even if we need to take a quick look down into the abyss just one more time first. But these measures alone won't save the Euro, only getting the periphery back to growth can do that, and at the moment the suggestion box seems to be empty on that count. Structural reforms alone will work neither far enough nor fast enough.

Root Of The Problem

But if the markets have gotten ahead of themselves in their enthusiasm there are reasons for this. So first a bit of background.

The root of the problem here goes back to the G20 summit in Los Cabos, Mexico, where an outnumbered Angela Merkel came under general pressure to accept an idea from the other Mario (Monti) to let the bailout funds (ESM, EFSF) buy Spanish and Italian government bonds to bring down borrowing costs. After the meeting the impression was given that Germany had acceded to the pressure and commited itself to the idea of "driving down borrowing costs across the single currency area", indeed the FTs Chris Giles and George Parker even asserted this phrasing to have been in the communiqué:

"Eurozone members of the group of G20 leading economies have committed to driving down borrowing costs across the single currency area, according to the communiqué from the summit in Mexico".

Reading through the text though, it rather looks as if they had been "had". There is no such mention, and the key reference sentence simply states,
"Euro Area members of the G20 will take all necessary measures to safeguard the integrity and stability of the area, improve the functioning of financial markets and break the feedback loop between sovereigns and banks".

More anodyne unimaginable. To add insult to injury, further down the body of the text it says:
"The adoption of the Fiscal Compact and its ongoing implementation, together with growth-enhancing policies and structural reform and financial stability measures, are important steps towards greater fiscal and economic integration that lead to sustainable borrowing costs"
Which is more or less pure Merkelese. So we shouldn't say we weren't warned.

Once Bitten Twice Shy?

Obviously, given the way leaked commitments suddenly disappeared in the concluding statement, we should have been prepared for the possibility that decisions which appear in a concluding statement may later disappear in the mists of clarification. We weren't, even though we should have been more on our guard the second time around.

Now according to the official version of what happened in Brussels a coalition of "Latin" states, lead by Mario Monti and Mariano Rajoy steamrollered the Angela Merkel into accepting policy measures which they had been pressing for. Der Spiegel put it thus:

"Italy and Spain were able to secure immediate measures to lower their borrowing costs at the European Union summit in Brussels on Thursday night. The agreement allows direct EU bailout aid to struggling banks, which Chancellor Angela Merkel had opposed".

Further, according to the statement issued after the summit, the meeting agreed that the ESM would be able to recapitalise Spain's banks directly.
We affirm that it is imperative to break the vicious circle between banks and sovereigns. …. When an effective single supervisory mechanism is established, involving the ECB, for banks in the euro area the ESM could, following a regular decision, have the possibility to recapitalize banks directly.
The measure was seen as an important one, with implications for other member states, as witnessed by the reference to Ireland that was included.
"The Eurogroup will examine the situation of the Irish financial sector with the view of further improving the sustainability of the well-performing adjustment programme. Similar cases will be treated equally".

So the clear implication was that Spains banks would be recapitalised directly, and that this would be done in such a way as to break the link between banks and sovereigns, and that while it was recognised there would need to be some kind of bridging measure - the statement affirms that "the financial assistance will be provided by the EFSF until the ESM becomes available, and that it will then be transferred to the ESM, without gaining seniority status" - it was assumed that the money would then be retroactively assigned to the banks themselves, by-passing the sovereign. The explicit reference to Ireland allows no other reading.

Yet on Friday the earth under our feet started to move, and with it the financial market assessment of Spanish sovereign risk. Matina Stevis reported on Dow Jones Newswires a conversation with a senior(but anonymous) EU official who stressed the following point:
“I need to make clear what the ESM can do: the ESM is able–if one were to decide ever on such an instrument–to take an equity share in a bank. But only against full guarantee by the sovereign concerned,” the official said. “What you have is that it cuts out the effect of that loan on the debt-to-GDP ratio of the sovereign. Does it still remain the risk of the sovereign or [does it go to] the ESM? It remains the risk of the sovereign.”
Charles Forelle sums the situation up quite aptly on the WSJ blog, what we have here is much less of a bold step forward and rather more of a neat exercise in accounting footwork.
Many in financial markets have assumed the ESM would recapitalize banks on its own–by giving them cash or high-quality bonds in return for equity stakes (or some sort of hybrid instrument, like contingent-convertible notes) in the banks. That way, the whole of the euro zone, and not just Spain, would bear the risk of the banks’ rescue. Yes, structuring the aid as a direct recapitalization does avoid the need for Spain to incur an actual liability to the bailout fund (and pay interest on its borrowing), but requiring that Spain indemnify the fund against losses just saddles the country with a contingent liability instead of an actual one.

What matters to investors trying to assess the viability of investing in Spanish government bonds isn't what it says on the official Eurostat EDP accounting docket, but rather the actual path of total Spanish debt (including contingent liabilities, and their probability of becoming actual ones) and the sustainability of that path. Sustainability issues may arise either because the total debt becomes too high, or because growth is too low, and in the Spanish case there are concerns on both counts, and especially if the Euro Group will not share losses in the Spanish banking system.

On the other issue, that of bonds purchases, the situation is less clearcut. True the statement did hold out the possibility of purchases:
We affirm our strong commitment to do what is necessary to ensure the financial stability of the euro area, in particular by using the existing EFSF/ESM instruments in a flexible and efficient manner in order to stabilise markets for Member States respecting their Country Specific Recommendations.

But in fact this possibility still exists, since the statement also affirms that any such use would be contingent on a prior memorandum of understanding, and a precondition for the drafting of one of these is that someone apply, and to date neither Spain nor Italy have made any such application.

So, in fact Der Spiegel was not actually being faithful to the letter of the statement when it argued the following:
The key to getting your way in tough negotiations, of course, is to find your opponents Achilles' heel. Italian Prime Minister Mario Monti and Spanish Prime Minister Mariano Rajoy did that on Thursday night and early Friday morning in Brussels. And the result is a euro-zone agreement to allow the common currency bailout funds to give direct help to ailing banks and to become active on sovereign bond markets to provide relief on the financial markets -- free of conditions for the countries in need of such aid.
Further down the article, the authors qualify the point:
In addition, emergency aid funds will in the future be made available to stabilize the bond markets without requiring countries, providing they are complying with EU budget rules, to adopt additional austerity measures.
This is the so called "virtuous countries" clause.

Something somewhere deep inside me chokes on the idea of considering Spain and Italy "virtuous" countries (in the economic sense, of course), since Spain's is surely not going to be able to reach this years deficit target of 5.3% of GDP (just as it failed to reach last years target of 6%), while Italy's gross debt looks all set to surge onwards and upwards as the country sinks deep into a recession of unknown duration. The phrase both claims too much for both of them, and too little for the other three who have already received bailouts (the non-virtuous countries, or sinners, I suppose).

Instead of being sanctimonious about this, what not be straight and up-front: Spain and Italy are large countries, with far more political clout than the others, and both Mr Monti and Mr Rajoy would be hard pressed to sell a bailout at home, in just the same way that the Euro Group would be hard pressed to fund one.

Where Do We Go From Here?

As we can see from yesterday's movement in Spanish yields, market participants have been left busily scratching their heads. Is the delay in bond purchases only temporary, or is there a more substantive problem looming? Certainly the threat by the Bavaria based CSU, sister party to Merkel's own CDU, to unseat the government, if necessary, is not reassuring. The FT reports they are far from happy with the terms of the "agreement".
"Horst Seehofer, leader of the Bavarian sister-party of Ms Merkel’s conservative Christian Democrats, warned that softening the conditions for funds would “at some point lead to the situation” in which his Christian Social Union could no longer support eurozone aid".
In addition the Finnish finance minister has now gone further, and suggested that her country might feel forced to leave the Eurozone should debt sharing - implicit in the direct bank recapitalisation - be agreed to.
"Finland is committed to being a member of the euro zone, and we think that the euro is useful for Finland," Urpilainen told financial daily Kauppalehti, adding though that "Finland will not hang itself to the euro at any cost and we are prepared for all scenarios. Collective responsibility for other countries' debt, economics and risks; this is not what we should be prepared for," she added.
Well, Roger Bootle should be pleased, he can take his shining new Wolfson trophy up there and see if he can recruit a client. In fact Finland must be one of the few cases where leaving the Euro Area might not be traumatic in its consequences, although I'm not sure how the decision would go down in neigbouring Estonia.
Our suggested exit path from the euro involves the overnight introduction of a national currency, with monetary amounts converted at 1 for 1, while the currency is allowed to fall well below this on the exchanges"
Whoops, the Finnish case wasn't contemplated - since their currency would doubtless rise, not fall - but still, it's all in a days work. Anyway, those sufficiently interested can find a simple set of rules for exit outlined in the following video.

Gamechanger or Gameover?

Yet no matter how positively or cynically we perceive what just happened, the fact of the matter is that this latest summit did produce results which, while possibly not being complete game changers, would in fact constitute a significant advance in the debt crisis if they were implemented, in particular since they do constitute steps towards that long promised banking and fiscal union. And basically, as I say at the start, even if it takes a bit of kicking and screaming first I do think they will be implemented.

Far and away the most important of these decisions was allowing the ESM to in principle fund Spain's bank recapitalisation. If followed through the decision will possibly come to be seen as a landmark one. My feeling is that the nervy events of the last week will not be the end of the matter, and that eventually a plan and timescale for setting up a banking union will be agreed on, since the costs of not doing so would obviously be far higher than those involved in so doing.

From now on at least a part of the costs of the Euro experiment's first decade will be shared by all those participating. The issue also serves to underline the fact that this crisis is not only about irresponsible fiscal policy. It is also about inadequate monetary policy and its after effects. Paying the costs of faulty decisions which were taken collectively should not only fall on the shoulders of a few - in this sense the Finns (true or otherwise) are wrong, this is not paying for others debts, it is about paying for joint and severally acquired ones. This is something I have been arguing for since 2007, so I can hardly not be pleased by this step.

The consequence is that with a "clean" implementation of the decision the entire Euro Area will now stand behind Spain'sbanks, as will Germany as part of the Euro Area, and indeed all countries in the monetary union would become become part-owners of at least some of Spain's banks. As Angela Merkel said last week, Germany can only thrive if her neighbours do, and now the German's will become stakeholders in the financial institutions of one of those very neighbours.

Markets would also be reassured by this outcome, since from that point it wouldn't really matter if the recent Oliver Wyman and Roland Berger reports gave a full and adequate reflection of the full mid-term recapitalisation needs of Spain's banks - if more money is needed there would be a mechanism in place whereby more money could be found. This is very different from having a Spanish sovereign which is teetering on the brink of being unable to finance itself having to try and guarantee a banking system which contains an unknown number of black holes. In this context it is not unreasonable to think that the Euro Area partners could eventually end up with a majority equity stake in the entire Spanish banking system, we will see. The good news is that whatever the final damage, there is now enough cement available to fill the hole, and we can stop playing around with polyfiller.

Beyond Spain - as the summit statement recognises -  the decision will also have implications for Ireland, and possibly - as I argued last week -  Slovenia (which also needs a bank recap and is starting to experience difficulty in financing itself). And in Ireland Deputy Prime Minister Eamon Gilmore is surely right, it will be a gamechanger, since Ireland's huge burden of sovereign debt would be significantly reduced as the equity holding is tranferred to the ESM.

From the Spanish point of view the counterparty here is that the government will now need to accept permanent European supervision of Spain's banks. The Bank of Spain is effectively about to become a local office of a European bank regulation system. Having seen what we have seen since 2006 this outcome can only be welcomed.

Virtuous Circle?

The second chapter included in last week's Brussels pact is much more complicated. The moral hazard problem here is going to be considerable. especially if the ESM does finally directly recapitalise Spain's banks. Once the threat of having a large sum loaded onto Spain's national debt from its troubled financial sector, Spain actually is left with a gross debt to GDP level which is below the EU average, even after all those unpaid bills have been paid. So Mr Rajoy could easily argue "where's the rush in reducing my deficit, I'm no worse than France or Germany" - German debt will, of course, have gone up due to its participation in the Spanish bank bailout. Complicated times.

So this is surely why Mario Draghi was not willing to initiate another intervention in the bond markets, and why the EFSF isn't yet buying Spanish bonds - Spain needs to reach agreement with Brussels on the measures  to go in the Memorandum of Understanding, and now Mr Rajoy is suddenly in less of a hurry than he was a week ago. Press reports suggest that Spain may need to undertake a further 30 billion euros in spending/revenue measures in exchange for an extension of the 3% budget target to 2014. This will almost certainly result in a stronger than anticipated economic contraction this year, and virtually guarantee a further sizeable one next year too. 

Italy appears to be struggling with this years targets too. Despite the fact that Mario Monti has just passed another 4.5 billion Euros in fiscal measures for this year (and a total of 26 billion Euros between now and 2014) doubts still exist the country will be able to meet its targets, largely due to the scale of the recession it has brought down on itself. Making what seem to me to be pretty reasonable assumptions, a team of Citi analysts lead by Jürgen Michels reach the conclusion that far from bringing the budget close to balance by 2014, the deficit in that year is likely to be around 3%, bringing gross government debt to GDP to the perilously high level of 137% of GDP. The IMF have it at 123% for the same year, and between these two numbers lies a chasm which if crossed will be hard for the country to work its way back across.

In addition Itay's political dynamics are now becoming particularly problematic, with elections looming next year, and many of the political parties now positioning themselves in anticipation.

So again, as in the Spanish case, the moral hazard issue looms large, as does the entire credibility of the programmes put in place so far. It's hard to make a strong claim they are actually working.

And even were the will to bail out both Spain and Italy there, it still isn't clear what the way is.

Allowing the ESM intervene by buying bonds raises the obvious issue that its notional €500 billion firepower would  be quickly used up. In addition calls on the fund are only likely to grow in coming months. Following the lead of  Cyprus last week, Slovenia is now more than likely waiting in the wings (see here). And before the year is out, a second programme for Portugal and a primary market support facility for Ireland are also likely to be  necessary.

Portugal risks missing this years deficit targets, partly due to a fall in revenue, and partly due to increased spending as a result of a strong surge in unemployment.

And as if all this wasn't enough, Portugal's constitutional court ruled last Thursday that the a government decision to withdraw public-sector workers' traditional additional two months salary payents between 2012-14 was unconstitutional, thus piling on the pressure on Prime Minister Pedro Passos Coelho to seek looser conditions for its bailout program.

The likely date for the second Portuguese bailout is September, following the rationale for the Greek one, since Portugal is programmed to return to the markets to finance bonds in September 2013 (an outcome which is extremely improbable), and the IMF has a “financing guaranteed 12 months ahead” rule. More than likely the country will need something over 50 billion euros - 24.2 billion for bond financing  in 2013/14, plus another 26.9 billion euros for 2015. Then there will need to be something to allow for the worsening economic scenario and the relaxed deficit conditions.

The Irish case is rather different, since the country has been promised a review of its programme in the light of the decision to give direct aid to Spain's banks. Bank recapitalisation has so far cost Ireland a total of €62.8 billion, or 40.7% of annual GDP, according to IMF data. Ireland's was the seventh most expensive bank recapitalization (as a share of GDP) on record and by the far the most expensive in recent history among the EU15 countries (with Finland’s early 1990s one coming second, at 12.8% of annual GDP). It is not clear at this point what kind of flexibility will now be shown to Ireland. A "low cost" option would be to allow the ESM to replace the 30.6 billion euros in promissory notes issued to recap the IBRC. Doing this would cut Ireland’s government debt/GDP ratio (which was 108.2% in 2011) by about 20% of GDP, and also cut future deficits by about 1% of GDP. The "business class" option would be to take all of Ireland’s bank recapitalization costs onto the ESM, which would cut Ireland’s government debt/GDP ratio by about 40% (and, of course, at the same time reduce the future deficit path). The most likely outcome is the low cost one, but still the impact on Ireland's debt sustainability would be important. The Irish government has said it is seeking a decision by end-October, to have more certainty over future funding needs as the existing bailout nears its planned completion at end-2013.

Which brings us to Greece. Ah, Greece! Well the government has admitted that the country is no longer "on track" to meet its programme' fiscal objectives.

The country has also stated publicly that it does not want to renegotiate the Memorandum of Understanding.

And the "men in black" from the Troika are now back in town.

So we look all set for a new set of deficit targets to be agreed, along with a hefty injection of European structural funds and EIDB money. As I suggested here, everyone now will have done their sums, and seen just how expensive it would be for Greece to leave (not to mention the contagion risks) so the current priority must be to find ways of keeping the country in.

Naturally stretching the austerity targets for Greece will also require fresh cash, but it is not impossible that a bit of creative accounting and juggling with numbers here and there could whisk this safely away and out of sight.

Looking through all this we can safely draw three conclusions.

1) September looks set to be a key month, as all the loose ends will need to be drawn together around that point.
2) None of the programmes put in place to date have worked as planned
3) The ESM will not have sufficient resources to meet all the forseeable calls on its funds.

The last of these issues has a simple and prgamatic solution. Unlike the ECB, which can create the money it uses for secondary market intervention, the ESM first needs to raise the funds it lends. Granting the ESM a banking licence which would give access to ECB funding and greatly ease the problem. The downside is that there is no public political will for this at present, and indeed Mario Draghi explicitly rejected the idea at last weeks press conference. Still, one thing we have all learnt in the two and a half years of this crisis is never say never.


What Can Be Done?

a) Shotgun Wedding
b) Full Banking Union
c) Common Fiscal Treasury
d) Central Bank able to act like the BoJ, the BoE and the US Federal Reserve
e) Less austerity and common finance to support the various economies while much needed structural reforms are undertaken.

This is just not doable say the critics. Well then, think about the alternatives for just 5 minutes and maybe you will change your minds.

No Easy Answers At This Point

Effectively I am suggesting turning the Euro Area into a second Japan. But Japan’s public debt path is not long term sustainable. There isn't any possibility Japan couldn’t exit the Yen, is there? I mean the country manifestly needs a much cheaper currency, yet despite issuing its own banknotes and being able to print somehow or other it doesn't seem able to achieve this (actually Joseph Stiglitz did suggest at one point the creation of a non convertable government issued second money to finance public spending, just as some have suggested for Greece). At present there are no capital controls in Japan, due to the presence of that famous "home bias" phenomenon whereby investors accept miserable rates of returns on their investments rather than sending their money abroad, but who knows, one day............

Basically we are faced with a complex set of problems which were never foreseen in economic theory. We don’t live in a perfect world. Angela merkel is wrong on austerity, but is right that in the longer run debt needs to be sustainable and our economies stable, even if that means accepting low, or even slightly negative, growth. Our intuitions are right, there are no free lunches. Stimulus can be good, depending on what else goes with it, but permanently living on borrowed time and running on “funny money” will inevitably end in tears.

As Paul Krugman put it recently, the Euro crisis has three layers - troubled banks, overlaid on troubled sovereign debt, overlaid on a deep problem of competitiveness created by runaway capital flows between 2000 and 2007 which lead to a huge problem of external indebtedness. The lastest summit decisions (when implemented) will help Spain address the first and second of these. But the big outsanding issue is still growth, a topic which was almost relegated to the sidelines given the extent of the other decisions. Economies in both Spain and Italy are sinking deeper and deeper into recession, and the 120 billion euro all Europe programme will hardly be sufficient to turn this situation around. Indeed in the case of all the rescued countries the same issues remains - where is the growth to come from? So while the summit outcome is certainly an example of yet another significant step forward, it is also a case of "oh so many rivers still left to cross".


And of course time is pressing, and it shows. The last summit statement concluded with the following words, "We task the Eurogroup to implement these decisions by 9 July 2012."

Having started this post with a piece the issue of press reporting of off the record remarks,  maybe it would be appropriate to finnish (no pun) with one. A representative of Finland's Finance Minister Jutta Urpilainen  (Matti Hirvola) has complained that the Minister never said  “Finland would consider leaving the eurozone rather than paying the debts of other countries in the currency bloc" in her interview (as reported by AFP). What seems to be at issue here are comments which are made on and off the record, and then how newspapers report the off the record part. After all, if you aren't prepared for debt sharing, the obvious question is what are you going to do if it comes (and it will). The natural response is "we are prepared for all scenarios", which is what they claim she said.

Curiously the report from the Finnish newsagency YLE which covers the story itself contains a good example of this kind of issue:
On Friday afternoon, the French news agency AFP cited an interview with Urpilainen published by the Finnish business paper Kauppalehti that morning. The wire service reported that “Finland would consider leaving the eurozone rather than paying the debts of other countries in the currency bloc, Finnish Finance Minister Jutta Urpilainen said".
In fact, Urpilainen said nothing of the kind in the interview. Rather she stressed that Finland is committed to euro membership and that “this is the message we must continue to convey”.
If you read the second paragraph again, the impression is given that it is YLE who are saying "nothing of this kind" was said in the interview, when actually it must be Matti Hirvola being quoted, since the YLE reporter was presumeably not present at the interview.
Since YLE themselves point to the Wall Street Journal's corrected version of the story, I think we can put the issue to rest with them:
Finland would rather leave the euro zone than pay down the debt of other countries in the currency bloc, Finnish Finance Minister Jutta Urpilainen said in a newspaper interview Friday.

"Finland is committed to being a member of the euro zone, and we think that the euro is useful for Finland," Urpilainen told financial daily Kauppalehti, adding though that "Finland will not hang itself to the euro at any cost and we are prepared for all scenarios."

"Collective responsibility for other countries' debt, economics and risks; this is not what we should be prepared for," she added.

Urpilainen's spokesman Matti Hirvola stressed to AFP that the minister's comments did not mean Finland was planning to exit the euro zone.

"All claims that Finland would leave the euro are simply false," he said.

In her interview with Kauppalehti, the finance minister meanwhile insisted that Finland, one of only a few EU countries to still enjoy a triple-A credit rating, would not agree to an integration model in which countries are collectively responsible for member states' debts and risks.
This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

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