The Euro crisis threatens to run out of control. Clearly the Spanish banks, which have bought most of the Spanish sovereign debt lately, with the help of the cheap loans from the European Central Bank [ECB], are shying away. We're not aware of any buyers of last resort, eager to replace them, hence rates quickly shot up to 6% on the 10 year bonds.
This whole situation is extremely dangerous, as the bag of tricks is considerably less full this time around. There is so much space for vicious cycles; it's really terrible to contemplate:
- Ever more austerity leading to ever sharper falls in output and tax income, needing even more austerity to meet the budget targets
- Worsening economies putting more downward pressure on asset prices, which worsens balance sheets of households and banks further, especially in those countries (like Spain and Ireland) which 'enjoyed' a credit infused housing boom that went bust
- Capital flight from the periphery, leading to falling money supply and worsening bank balances, needing ever more injections from the ECB to repair
- Ever more infusion of central bank money into the banking system, leading these banks to buy ever more sovereign debt of their home country, which worsens their balance sheets even further and risk taking their sovereigns with them when they need to be bailed out.
Austerity GDP vicious cycle
The scary stuff on Tuesday was that the Spanish government hastily announced a 10B euro additional austerity measure to placate the markets, but this didn't stop the rout in the Spanish bond market even for a moment. It remains to be seen whether they're worried about the Spanish authorities not doing enough, or whether they're actually worried they're doing too much. The Jury is still out on that one.
Spain was already embarking on a 2.5% of GDP fiscal squeeze, without any offsetting monetary stimulus or devaluation. It now has announced additional 10B euro austerity measures. House prices fell 11.2% in Spain last year.
Portugal expects GDP to fall by 3.3% this year. Greece's GDP is off the radar screen now, as most of the debt is now in official hands, but its plight will be even worse. Italy is cutting 3.5% of GDP off the budget, which is near primary surplus anyway, and its economy is also in a recession. Ireland, briefly hailed as an austerity success story, has sunk back into recession.
There are even gloomier scenarios, including Morgan Stanley's "bear case" scenario for the Euro zone, which would see the Spanish economy contract by nearly 4pc this year, and Greece shrink by 6.7pc (compared with -2pc and -5.5pc under its base case scenario). [Telegraph]
You might think that the ECB, embarking on ultra loose monetary policy, has a mitigating influence in the Euro zone periphery. Think again:
Real M1 deposits have contracted at a 10.9 annual rate over the last six months in the peripheral bloc of Italy, Spain, Portugal, Greece, Ireland, a leading indicator of trouble later this year. [Evans-Pritchard]
In short, the peripheral economies are suffering from terrible recessions, embarking on policies that worsen these, without any offsetting monetary stimulus or devaluation. The suffering (unemployment is at 24% and rising in Spain, in double digits in Portugal, Italy and Greece, youth unemployment in Spain and Greece is at 50%) and destruction of human capital is at depression levels.
One really could wonder whether it is all worth it. The terrible irony is that the jury is still out on whether all this suffering has actually brought fiscal prudence and prosperity any closer.
Banks-Sovereign debt dynamics
On the whole, European banks are terribly overleveraged. Europe's banks have a loan-to-deposit ratio of almost 1.3, like Japanese banks after the Nikkei bubble. The ratio for US banks is close to historical norms at 0.7. There are (at least) four negatives at work in the Euro zone banking system:
- In some countries (Ireland, Spain), they are still digesting the bursting of a housing bubble, with household balance sheets worsening with the terrible economic conditions and further falls in house prices wreaking havoc on banks balance sheets
- Capital flight is ensuing from the periphery to the center. Why would bank investors and depositors put their money in peripheral banks when they can invest/deposit with German banks at no currency risk? So capital is fleeing from the periphery to the center, with the ECB having to pick up the pieces
- Capital ratios have been mandatory increased in a bid to strengthen the weak European banks, but instead of raising capital, the banks are embarking on selling assets and reduce lending, creating a credit crunch in the process
- Buying sovereigns with cheap ECB loans seems like a brilliant ploy, and has indeed bought a few months of relative calm, but when banks in the periphery, already plagued with investor and depositor flight, load up on their sovereign's debt with cheap ECB money, their balance sheet only becomes that much more vulnerable. What's more, when they get into problems, reductions in lending will worsen the economy and bailouts, and when necessary, will worsen public finances further.
Let us illustrate some of these points. To start with the housing trouble, Spanish banks lost some €2B in the final quarter of last year as the property bust deepened. According to Spanish quality newspaper El Pais, the European Commission is prodding Spain to tap the EU's bail-out fund to help restructure the banking system and head off a serious credit crunch.
To remain with Spain, Spanish lenders have increased their dependence on loans from the European Central Bank to a record €152bn, using the money to roll over debts or buy Spanish government bonds - concentrating risk further.
Spanish banks used the first LTRO to boost holdings of sovereign debt by 29pc to €230bn, with a similar pattern in Italy. The weakest banks are buying the weakest government bonds, often in volumes that exceed their equity base. "It is a levered option on sovereign risk," said Alberto Gallo, a credit strategist at RBS. [Telegraph]
Things have gone the same way in Portugal:
Domestic institutions now hold about 30% of o/s debt, up from 16% in 2011 [Ritholtz]
With respect to the capital flight, we have already noted above how the money supply in the periphery is shrinking, and since many banks don't have access to the capital markets, they're reacting to the new requirements for tier1 capital by
Ergo they flip the ratio and start burning off risk-weighted assets. They are going to sell loan books in extremis, it will cause a credit crunch, (already occurring of course) and deflation will ensue as the supply of money falls [FT Alphaville]
We'll leave you with James Ferguson from Arbuthnot Securities:
In a fractional banking system, the way money supply is created is through initial bank lending and then the workings of the money multiplier. When banks cease making new loans, money supply growth stops; when they start demanding the repayment of existing credit, the process goes into reverse and money supply is destroyed. To prevent deflation (defined as a contraction of nominal broad money supply) Japan, the US and the UK were all forced to carry out QE, thereby keeping money supply from shrinking, at least in the latter two cases. There is no reason to believe that the euro zone won't be forced to react in the same way when faced with the same problem, at least once the ECB repo rate has first been cut to (near) zero.
This was a prediction from last October, but the shrinking money supply in the periphery has already arrived.
There isn't much the authorities can do:
- The ECB might engage in buying bonds again; they haven't done so for a while
- They could inject another round of cheap capital (highly unlikely anytime soon, but perhaps if the crisis becomes so acute, they'll pull another rabbit out some hat)
- Spain might invoke the emergency funds (EFSF and ESM) in order to stop the rot. If announcing 10B euro in additional budget cuts didn't do it, we're in a rather acute crisis. If rates keep going up like they have done the last week, Spain might not have an alternative, or?
- That is, if the rumors that Spain is in talks with the IMF hold any currency, they might have. That would be about the last trick around (at least in the realm of the possible) that could save the day.
ECB bond buying seems the most likely weapon to keep rates manageable. One argument against them surely can now be put to rest. Previously, when countries hadn't showed enough on the policy front in terms of austerity and structural reforms, the ECB could argue that it was not up to them. There always was an implied quid pro quo.
However, with both Spain and Italy embarking on serious reform and austerity, that reason for hold-out by the ECB is much weaker now. And lets not forget, when rates threatened to spiral out of control completely at the end of last year, the ECB blinked first (even though it was instrumental in the downfall of Berlusconi).
Indeed, no sooner than we could write these lines (Wednesday morning), the following article appeared on Bloomberg:
European Central Bank Executive Board member Benoit Coeure triggered speculation that the bank will revive its bond-purchase program to lower Spain's borrowing costs as the region's debt crisis threatens to boil over again. Spanish "market conditions are not justified," Coeure, who heads the ECB's market operations division, said at an event in Paris today. "Will the ECB intervene? We have an instrument, the securities markets program, which hasn't been used recently but it still exists."
So over to you, ECB..
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.