Sense and sensitivity

I have been ranting against Germany's ideological crusade and their (lack of) sensitivity to the need for immediate action to disarm the crisis NOW! According to a document leaked from the EU president Van Rompuy’s office, it is clear that at tomorrow's EU summit, a small number of reasonable initiatives will be on the agenda.

I have suggested that one element in getting the crisis to go away is to convert the highly indebted countries' short-term debt to long-term debt instead. If you read the leaked document (attached), it is clear that something is happening on this issue.

EU will discuss to 1) accelerate the process to get EFSF up running with gearing and everything, 2) accelerate the ratification of ESM for this new institution to get started on long-term lending and 3) make "deposits" in the IMF, which can then lend money to European countries with large short-term financing needs.

Importantly, EFSF and the ESM could be allowed to operate in parallel for a while, increasing their lending capacity.

If carried out, it is good news. And should be received by financial markets as such. If not it hurts the poor Germans on their sensitivity.

My checklist to find out if new initiatives are useful to resolve the crisis has the following five elements:

• The ECB to act as a central bank
• The banks to be recapitalised
• Countries with huge short-term debt should have them converted to long term debt - very long term
• Germany and other countries in a good situation stimulate domestic demand and growth
• Structural development in the indebted countries (lend them money to build a bridge between some islands or similar)

This list can serve as a reality check: if new initiatives fit into one of those categories, then it is good news. If not, they are irrelevant or downright dangerous.

Fast track union changes will not help

France and Germany are pushing on with fast-track treaty changes, trying to find the loopholes that will allow the Euro-zone to impose German-style budget discipline on the other member countries without being bogged down by democratic procedure.

Presumably it means that the ECB subsequently will be allowed to act like a central bank. Or at least one hopes.

I  have come to believe that Germany still does not get it. The German policy is consistent, but wrong. The method for budget discipline now being pushed is just an über-version of the tragically mis-named “Growth and Stability Pact” (PSG), Germany’s contribution to the euro from 1997.

Already back then, economists pointed out, that the PSG would be procyclical. It means that a country typically runs a (bigger) budget deficit in a period of slow or negative growth. The PSG was then intended to impose cut-backs on countries already having economic problems. It would deepen the problems, hence causing even bigger cyclical swings on the country in question.

We all know that the PSG was largely ignored – even by Germany, when it found it necessary.

It is correct that budget discipline and a manageable government debt are necessary for long term stability. But it will not work to impose deflationary policies on the other Euro-zone countries, when growth is desperately needed to in order to grow out of the deficit situation.

In order to balance the European economy, Germany needs to support the weaker Euro members with long term loans to the most needy and by adding to domestic German demand.

I agree with the German vision that it is better to have an economy based on producing things people actually need. But structural changes cannot be introduced quickly. Greece and Portugal will probably never be efficient producers of reliable hairdryers, much less advanced tool machines and industrial robots. Such changes take years, and in the meantime economic growth will be depressed.

So here is a yardstick by which you can measure the various ideas being touted in the press. It is good news if it brings us closer towards one of following:

• Long-term loans to the countries in problems
• Stimulation of demand in the countries that can afford it
• Co-ordination of economic policies to stimulate demand
• Help to structural development where needed
• ECB to assume the role of a real central bank.

If a new policy idea or international agreement does not bring us closer to any of those elements, it is either bad news or quite simply irrelevant.

Whether this will end in a deep depression (as the OECD warned yesterday) or a long period of slow growth, nobody knows yet. But if the scale tips towards the depression outcome, Germany will suffer more than believed today. Ouch!

12 reasons for the markets to be paranoid

I cannot really find anything interesting in today's news. So let me instead use some space to summarise my views on why it is so difficult to operate in today's markets.

I have on earlier occasions expressed that at no other point in my career have I had to dig that deep in remote corners of my memory to find tools that can help me to understand. Yesterday one had to dig into the conditions for European government bond auctions (French primary dealers must bid at the OAT auctions, German primary dealers can abstain from Bund auctions if they like).

The day before yesterday one had to understand the unique American tradition of planning government expenditure programs over 10 years - which means that one cannot really count on anything. Last week we had to go over the ECB's charter to understand whether a modification of the charter also requires changes to the Lisbon treaty. And so on.

But we take a deep breath and list the factors that currently have conspired to ruin our night's sleep:

1. A secular reversal of a 15-year trend where households in many countries have increased their financial leverage significantly
2. A normal cyclical slowdown in the cyclical upturn that began in 2009
3. Government austerity programs across Europe, beginning in 2010
4. Additional public sector cut-backs in 2011
5. A dramatic reassessment of the price of risk - and perhaps even a new understanding of risk
6. Europe's central bank does not have the necessary authority to conduct a monetary policy that can effectively help us out of the pinch
7. European banks have opposed a recapitalisation and are now zombies, are forced to reduce their balance sheets dramatically now (remember Japan!). The U.S. banks are still struggling with the aftermath of the Sub-Prime crisis
8. Strong ideological determination in Germany to use the opportunity to shape important aspects of European political cooperation after the German model
9. Southern European countries, which for years have opposed productivity-enhancing reforms and general budgetary discipline
10. Maximum increase in the number of retirees (born 1945-50) putting pressure on state finances independently of the financial markets
11. Large institutional investors are still forced to abide by the rating firms' views, even if these views are deeply compromised
12. China's growing influence on world economy and the derived effects when even China has "slow" growth

I could probably find a few more. It is not necessary. There is already plenty.

My biggest problem is not really that the situation is complex. It is that the vast majority of communications in the financial sector has been shortened to a point that it can also be read by people with profound attention deficits.

Contagion defined

While we wait for the all-encompassing, gold-plated solution to EU's institutional problems, one could reflect on the term "contagion”. The concept has been used so often in recent months that we have almost become immune to its possible meaning.

Progressive distrust
I suppose it means that distrust of one kind of assets (Greek government bonds, for example) leads the financial markets to lose confidence in other assets - such as Italian government bonds. In the financial markets it means that the price of the suspected asset drops to reflect the new perceived risk of owning the asset. Completely logical, this.

So "contagion" means that investors reassess risk on assets one by one, and it implies that prices adjust - mostly downward. Contagion is therefore a sign that the markets have begun to think. This should create some concern, since the markets not exactly known for composure when they find out that they have been wrong.

Risk reassessed
Since 1998 it has been Standard Operating Procedure that when something went wrong in the world economy, interest rates were lowered and ample liquidity was supplied to the market. Since Asia during the same period took over the production of industrial goods, this policy did not stoke inflation.

Yields on government bonds fell, and in an attempt to achieve higher returns, institutional investors around the world dramatically increased holdings of low-quality bonds and equities. As a result risk premiums fell dramatically.

A clear example is that the Italian government bond yield was less than 20bp higher than German government bonds back in 2005. A clear sign that the risk was severely underestimated and the risk premiums had fallen too far.

We think and we re-think
The banking crisis in 2008 meant that market participants again are thinking about the correct price of risk. With usual decorum and restraint, the financial markets have entered into a permanent state of catatonic shock.

In other words, the "contagion" translates into a progressive understanding that risk should be reassessed. It seems that politicians everywhere find that such knowledge must be stopped by all means before it goes too far.

A potential victim of risk re-pricing : U.S. overconsumption
Now think what could happen if the markets began to ask critical questions about the World’s largest debtor by far, the US of A.

It would mean sharply higher U.S. bond yields. The burden of debt service would force a reform of public spending and taxation. Consumers would be forced to save instead of borrowing. Businesses would have to rely more on labour instead of cheap capital.

The road to get us there would certainly not be smooth and without obstacles. But "contagion" might ultimately not be the worst outcome. 

Risk willingness increases

Despite the continued uncertainty over what will actually be done in order to stabilise Greece and the European banks, G20 meeting in the weekend 15/16 October delivered enough details and pointers that the financial markets will begin taking the risk premium out of the market. Later on, it could develop into some kind of euphoria that will turn upside down everything that has happened in the past few months. It started two weeks ago as the first rumours of a comprehensive solution began to circulate and it can continue for a while, at least.

Bank crisis solution

Our often repeated take on the situation is that at least two crises overlay each other: Greece, and a general debt crisis, which in turn reflects itself in a very unhealthy banking sector. As I have stated earlier, Greece must have a debt restructuring in order to get out of the mess, and that will lead to some serious cash injections to the banks. The US banks already got their no-strings-attached social help three years ago, and the European banks will probably receive their gift vouchers over the coming six months. 

A classic “risk-on” reaction

In concrete talk, “taking the risk premium out” means: 

• Stocks will gain, possibly lead by the bank stocks, and primarily in Europe. 
• Bond yields on higher-rated sovereigns will increase, the yield curve will steepen.
• Yield spreads of lower rated sovereigns over higher-rated sovereigns will narrow, in some cases sharply. 
• High yield bonds will see the their yield spreads over government bonds narrow but at a slower pace than what happens in the spread between high and low rated sovereigns.
• Dollar will weaken against the Euro and so will other “safe” currencies.
• Commodity currencies will increase against the USD.
• Commodities (primarily industrial commodities) will rise moderately, and oil will receive a boost.
• Gold may fall further, as the “safe haven effect” vanishes.

It may look like an asset rotation, but we not yet seen market volumes corresponding to a major move of capital between asset classes.

A new divergence is building

A bit further out another theme is building. The markets had not seen the sharp slowing of the global economy as late as one week before the stock markets fell out of bed in early August. “The End of the World” is still very much on everybody’s mind.

At some point the markets will realise that apocalypse is not now! Nor indeed anytime soon. The risk-on scenario will then be followed by a proper risk-rally. It will probably last for some months before the underlying longer-term problems again are taken seriously. The debt crisis has not gone away, and it will continue to subdue growth for the coming years. It will be uncomfortable (particularly if you work in a bank), but not disastrous. 

Inching closer?

It could very well be that we are in the last weeks before the Greek debt restructuring. At least we hear more and more noise from the Euro-group about the terms of the haircut private sector bond holders will have to take.

On 21 July the Euro-group members presented an agreement whereby the Greek debt would be written down by 21 per cent. It did not take long time to calculate that even with the economic reforms agreed by Greek government at that time, it would not be enough. Greece needs a combination of spending reductions and debt reduction in order to get back from the dead.

With the 21% debt write-off, it would take very optimistic assumptions about future Greek economic growth in order believe that the “primary” surplus (government revenue minus expenditure ex debt service) could be sufficient to cover the servicing of debts to the tune of 170 per cent of GDP.

Several sober estimates have consistently pointed to a haircut between 50% and 70% in order for Greece to get a fresh start. That matches exactly what we now hear from the Euro-zone, namely that “more than 50%” of the debt will have to be written off. It is a great step forward that the truth is finally being tabled.

But, it is not over yet. ECB apparently is against the idea of a Greek haircut of 66%. Instead ECB insists that the 21% “voluntary” haircut must be implemented. One could wonder why, given that a haircut of 50-70% is the only thing that makes sense. Probably it has a lot to do with politics (I will not be so mean as to suggest it could have something to do with the Greek bonds held by ECB itself!).

Let us assume that the banks take the 21% haircut. In that case they would probably need only a minor capital increase, and it would possibly be possible to find that money in the market. Shareholders would be happy and the interbank market would unfreeze rapidly. No wonder the banks endorse this strongly. It would be a carbon copy of the US “money-for-nothing” program, called TARP.

The problem is that in order to arrive at a debt reduction of 66%, EFSF and the Euro-zone countries somehow would have to finance the difference between the bank’s losses and the necessary debt reduction. One could imagine that EFSF simply would underwrite difference or take over the Greek government bonds at artificially inflated prices. This would amount to a de facto gift to Greece and/or the banks.

That would be just about the worst thing that could happen for Chancellor Merkel and the other European leaders. Their electorates could rightly claim that their governments had just rewarded Greece and the banks for their recklessness.

Let us instead assume that the haircut is fixed at 66%. The banks for sure would need capital injections from their governments. In that case the governments will be able to present the expenses as a help to domestic banks and not as a rescue of the reckless Greek. The governments would for an extended period of time take control of the banks. That would be far more palatable for the electorate.

Either way, Europe’s governments will end up having to foot the bill. The difference is in the resulting relationship to the banks and the electorate. It is easy to see why politicians prefer the larger haircut. It is equally easy to see why the banks prefer the 21% haircut. 

Could the markets have got it wrong?

It is a dangerous game to say that the markets are wrong. As JM Keynes noted: The market can stay irrational longer than you can stay solvent.

Nevertheless, there are some elements of the developments in the last week that are worth a comment.

We have heard US Secretary of the Treasury Geithner tell us that Europe is acting too slowly and that we have to act in order to avoid a disaster. We have read tons of analyses of the Eurozone debt problem, built on dubious assumptions. And we have seen economists who 3 short months ago trumpeted a return to strong growth re-brand themselves as doomsday prophets. 

The underlying economic situation is serious, but not because of the issues that are now driving the crescendo. The Western World has over the past years built a mountain of debt which is clearly unsustainable. The main culprits are the private households who in line with falling interest rates have leveraged themselves harder and harder, mainly in the property market.

Public sectors have “taken over” some of the debt during the first phase of the Great Contraction in 2009 and 2010. Countries with a weak budget discipline have been pushed in the direction of something quite unsustainable. This affects primarily the US and in second line, the UK.

The historically high Debt/GDP ratio will slowly be reduced in the coming decade. As the banks are the pivot in the debt explosion – no banks, no loans – a deleveraging will automatic lead to a shrinking of the banks’ balances. This process is progressing, but is slipping under the radar of the financial markets.

Instead, the markets are busy with something as relatively unimportant as Greece. Government after government has been lying about the real economic situation, and Greece now faces a default. It appears that the Eurozone is about to arrive at a solution that will allow an orderly default, assuming a 50-66% haircut.

This would imply a loss for (European) banks up to €130bn. A large amount, but not impossible to handle. The data released in relation to the European “stress” test showed that a default of this magnitude is possible to control.

Then we have Portugal and Ireland, which at this moment in time do not finance themselves in the open markets. They work to reduce their government deficits. Ireland has progressed nicely and is ready to try a fresh bond issue some time in 2012. There are no reason to expect that these two countries should default on their loans.

Spain is frequently mentioned, even if the country has a relatively low government debt, and a government deficit lower than those of the USA and the UK.

Italy has a government debt of some 120% of GDP, the same as 10 years ago. Reforms have been introduced that will reduce the government deficit to acceptable levels over the coming two years. There will be a significant surplus on the primary budget balance, ie. before interest payments on the existing debt.

There is hardly any reason to believe that Spain or Italy should default on their debt. However, the panic in the financial markets has reached levels that probably requires that EU provides sufficient credit facilities that both countries for a while could cover their financing needs without tapping the markets. This is not a situation based on facts, but on panic.

Then there is the interbank market. The diffuse fears of losses in the European banks have led to a freeze in the interbank market. Central banks have reacted correctly and provide liquidity in order to avoid a replay of the Lehman collapse. A further deterioration of the situation  will not come from this source.

All in all it is a complicated situation where several stories are playing out on different levels. Stock and commodities markets have reacted with a huge increase in risk averseness. A quite understandable reaction, but not particularly logical, given the facts.

But what will happen once Greece has defaulted and the European credit facilities have been increased X-fold?

Then we can return to the really ugly story, namely that OECD needs to bring the debt situation under control. As I have written before, this will imply an extended period of sub-par growth and shrinking bank balances. This problem is not isolated to Europe.

The good news is that even in such a situation, it will be possible to have well functioning markets. The bank sector, however, will see no solution to its problems with the capital base as well as with bad loans.