Well first of all, a very Happy post-Xmas to any of you foolish enough to be reading tiresome posts like this one. A tiresome post which simply starts by going into some nitpicking follow-up detail to my earlier post on ECB liquidity and monetary policy separation - That Which The ECB Hath Separated, Let No Man Join Together Again! But it then starts to explore the rather more torrid topic of what exactly Latvia's Regional development minister Edgars Zalāns might have had in mind when he told the Delfi news portal that the Latvian agreement with the IMF and other lenders could "easily be amended given its shaky legal grounds" (there, that made you hiccup-back-up some of your xmas-pud, now didn't it?). Or what Prime Minister Valdis Dombrovskis might have been getting at when he warned that “We will just go bankrupt if we observe all legal norms.”
But first some really tiresome (but important) details on the ECB, since the bank effectively wound up its anti-crisis program of extraordinarily long-term lending to banks last week with a final one year funding operation that is likely to keep short-term euro interest rates ultra-low at least for another six months. The general opinion is that the tender outcome suggested that much of the banking system can now live without the ECB's life-support mechanism, although a number of banks are still highly dependent on it.
The ECB injected 96.937 billion euros into the banking system in the third and last of its 12-month lending operations. As in the previous two 12-month tenders, the ECB gave banks all the money they asked for. However, in contrast to earlier tenders, it said the effective interest rate wouldn't be a fixed 1%, but rather would be tied to the average rate at the main one-week refinancing operations over the next year.
The general opinion is that last week's allotment - which will increase the total amount of ECB money in the market by around 14% - will keep the Euro Overnight Index Average, or EONIA (the key rate for interbank overnight money), around its recent level of 0.30%-0.35%. Actual overnight rates have barely moved from this level since the ECB's first 12-month tender - the whopping 442.24 billion euros allocated in June - created a structural surplus of money in the market (this was obviously the intention) and reduced the cost of borrowing well below the ECB's own targeted refi rate of 1%. And it is here that tiresome little detail comes into play, since while the EONIA rate is unlikely to move from its present levels in the short term, once the funds from this first 12-month tender mature next June (thus removing much of the excess liquidity currently in circulation), the EONIA rate will in all probability start to move back towards the level of the refi target rate, which is where it normally stands.
So I want to qualify a point I made in my previous post since this upward movement in EONIA, which will be provoked by the ending of the one year funding programme, will constitute some form of monetary tightening, albeit a rather marginal and insignificant one.
At the same time, the recent decisions do not mean a complete termination of ECB lending operations to banks in the Eurosystem, since while the six-month tender due in March will also be the last, the three-month tenders the ECB had offered since its inception in 1999 will still continue, although it is not clear at this point whether these will have ceilings or not. Basically, all these moves form part of the bank's plans to end its non-standard policy measures over the course of 2010, even if it is unlikely to intentionally do anything to make matters worse for the troubled banks. Provided that is, their national governments play ball with the structural reform programmes being advocated by the EU Commission.
Fewer Banks Borrowing More Money - And No Prizes For Guessing the Culprits
The number of banks bidding (224) was down by more than 60% on the 589 who participated in the previous 12-month operation in September, indicating that fewer banks now need such help. The banks that do remain dependent on the ECB, however, appear to be even more dependent than they were three months ago, since the average bid rose from 128 million euros to 433 million. While the ECB refuses to comment on which banks participated in the tender, it seems pretty clear that they were concentrated in countries on Europe's periphery (Greece, Spain, Ireland, possibly Austria). And indeed last month, the Greek central bank specifically urged Greek commercial banks to show restraint in the coming tender, and not increase their dependence on ECB funding.
Credibility Under Strain
Which brings us all the way round to Latvia. It is hard to assess the likely impact of the Latvian constitutional court decision that pension cuts included in the recent IMF-EU package are not legal. But personally I find the decision rather significant (for a discussion of the background see my post Latvia Is Back In The News, And Expect More To Come) since pension reform lies at the heart of the whole structural reform programme currently being demanded of "risky" EU states by the IMF, the EU Commission and the Credit Rating Agencies. Indeed, the whole credibility of the EU's ability to manage its own affairs could be called into question here. As Angela Merkel recently said:
If, for example, there are problems with the Stability and Growth Pact in one country and it can only be solved by having social reforms carried out in this country, then of course the question arises, what influence does Europe have on national parliaments to see to it that Europe is not stopped.....This is going to be a very difficult task because of course national parliaments certainly don't wish to be told what to do. We must be aware of such problems in the next few years.
Well, I am sure some of our leaders must be becoming more and more aware of the problems presented with every passing day. Prime Minister Valdis Dombrovskis seems to understand the gravity of the situation “We will just go bankrupt if we observe all legal norms.”
My considered opinion is that it is the political pressures inside those countries (whether inside or outside the Eurozone) forced down the road of internal devaluation which can ultimately cause the agreements they enter into to fall apart, ultimately leading - in the Latvian case, and as Dombrovskis recognises - to sovereign default. This is bringing others (in the Latvian case, Estonia and Lithuania, or in the Greek one Spain) crashing down behind them.
As Baltic reports rightly put it:
The Constitutional Court’s ruling Monday that the decision by Latvia’s government earlier this year to lower pensions had violated the Satversme will, at the very least, force a new round of talks with international lenders and could trigger a new wave of political instability.
And as we should also note, the Constitutional Court also ruled that the government’s agreement with international lenders was also unconstitutional in that it hadn’t been approved by parliament. This takes us back to Merkel's point, and the absence of institutional mechanisms for the EU - under defined circumstances - to over-ride the sovereignty of national parliaments (what a hot potato that one is).
Not Simply A Latvian Issue
And the issue isn't simply confined to Latvia, since we should not forget that Hungarian voters held their own referendum in March last year, where they effectively threw out a set of health charges introduced by the government as part of an "austerity programme" designed to bring Hungary's surging public deficit under control. And the long term financing of Hungary's health system has still not found a satisfactory solution.
I would also draw attention to this paragraph from my last review of the situation in Greece:
We should also not fail to notice that Greece also had to raise 2 billion euros in debt via a private placement with banks last week, against a backdrop of credit downgrades and steadily rising spreads. The ECB undoubtedly agreed to this given the degree of policy coordination which must exist behind the scenes, since they are the ones who are financing the Greek banks, but it does highlight just how things have moved on in recent months, since only last year it was imagined that the Eurozone in and of itself gave protection from this kind of financing crisis, which was why only eurozone non-members, like Latvia and Hungary, were sent to the IMF. Now it is clear that while the ECB could keep protecting Greece from trouble till the cows come home, they cannot simply keep financing unsustainable external deficits and retain credibility. In this sense the financial crisis has now “leaked” into the Eurozone. And this has implications I would have thought, for countries like Estonia, who see eurozone membership as a “save all”. And obviously, the EU authorities badly need to plug this hole in their armour, or the entire concept of the eurosystem can be placed at risk, which is why I think we won’t see an explicit slackening in the minimum acceptable rating criteria.
So a very large credibility issue is now looming, and one which is leaving a gaping hole waiting to be plugged in the outer defences of the Eurozone.
Where Ireland Fearlessly Treads, Spain Fears To Wander
One of the policies which will undoubtedly be applied by the EU authorities in an attempt to bring this situation under control will be one of being seen to favour the "good students" against the flunkers. By good students here we may think in terms of countries like Estonia and Ireland. Estonia is clearly going to be "rewarded" in some way or another for its "solid performance" in the face of the crisis (if that is, it isn't inadvertently dragged kicking and screaming off that same cliff from which Latvia seems destined to fall), while Ireland will receive all the protection the ECB is able to offer and that, as I am stressing, is plenty. Mr. Trichet's strident insistence that EU countries were like US states would end up being rather hollow if the eurosystem were to prove incapable of offering aid to one of its members who was following instructions and struggling for survival.
As in the case of Spain, a large part of the Irish debt is owed to foreign banks and bondholders who, rather than domestic Irish depositors, were responsible for funding the property boom. And, as the FT's John Murray Brown points out, the net indebtedness of Irish banks to the rest of the world rose sharply, from 10 per cent of GDP in 2003 to 60 per cent by early 2008.
But while the very survival of both Irish banks and Spanish Cajas has been increasingly questioned, the Irish government has stepped in to shore up their asset side by agreeing to take over the worst of the sector’s property loans, via the creation of the new National Asset Management Agency (NAMA), in a way which contrasts strongly with the Spanish authorities who have simply limited themselves to denying there was any real problem.
Despite all the jitters about Irish sovereign debt in light of the forthcoming annual fiscal deficits, what debt investors are really concerned about is the state’s huge contingent liability following the decision in October last year to guarantee all deposits and most debt of the five biggest banks. Analysts calculate that if there were a run on the Irish banks, the state would not realistically be able to find the 400 billion euros – an amount twice the size of Irish gross domestic product – the might need to meet their potential obligations under the guarantee. But this nervousness is to miss the central role the ECB would play in just this situation (should it arise, which it probably won't due to the credibility of the ECB guarantee). If the ECB were not able to shore-up Irish finances in times of crisis, then I think the Eurosystem would already be history.
But Spain is a very different problem, and a much bigger threat, not only because of its size, and the size of the debts, but also because Spain, unlike Ireland, is turning a deaf ear to European Council "advice". The banks have accumulated large quantities of houses and land on their balance sheet, and no one knows their actual value. And there is a stock of around one and a half million unsold new properties awaiting buyers who may never arrive. And with the continuing inaction, the nervousness only grows. As Bloomberg's Charles Penty points out in an excellent review article, the “skeletons” on the balance sheets of Spain’s banks are making many fund managers averse to the acquisition of stocks with a strong dependence on the Spanish internal market . He cites the case Alvaro Guzman, Managing Partner with Bestinver Asset Management, whose funds have been the best Spanish performers over the past decade.
"We are very pessimistic on Spain because we think there are still skeletons to come out of the cupboards -- basically marking to market the true value of real estate on the balance sheets of the banks,” Guzman says, “It’s not just the banks we’re out of but anything that has a Spanish cyclical component.”
Among Bestinver's concerns is the fact that the crash of the Spanish real estate market, which caught banks with 324 billion euros in loans to developers, will limit economic growth and tax revenues (an echo here of S&P), perhaps forcing the need for an eventual bailout by Germany (or France). And, of course, Bestinver's view is far from an isolated one. Penty produces another telling quote, this time from Jim O'Neill, Chief Global Economist with Goldman Sachs, who told Bloomberg radio that it was going to be important to see whether further damage to Greece’s credit ratings sparks a “cascading game” where the “market just starts going after Spain or Portugal." You bet it is going to be important.
Testing Days Ahead
Evidently Europe's institutional structure is in for a very testing time, and new and imaginative initiatives are going to be needed. Sovereign risk has now spread from non-Eurozone countries like Latvia and Hungary, straight into the heart of the monetary union in cases like Greece and Spain. Mistakes have been made. As I argued in my Let The East Into The Eurozone Now! piece back in February 2009, the decision to let the Latvian authorities go ahead with their internal devaluation programme never made sense, and the three Baltic countries and Bulgaria should have been forced to devalue - the writedowns swallowed whole - and admitted into the Eurozone as part of the emergency crisis measures. This situation has simply been allowed to fester, and in addition the much needed change in the EU institutional structure - to allow Angela Merkel the power she is asking for to intervene in Parliaments like the Latvian, Hungarian, Greek and Spanish ones, as and when the need arises - has not been advanced, with the result that we are increasingly in danger of putting the whole future of monetary union at risk. It is never to late to act, but time is, inexorably running out. As the old English saying goes he (or she) who dithers in such situations is irrevocably lost.