On occasion of an interview he gave to Germany's Süddeutsche Zeitung, the current head of the euro-group, Jean-Claude Juncker, last week painted a stark picture of the euro area's future if the Greek debt can were not successfully kicked down the road one more time. Evidently, calming the markets cannot have been the goal of these apocalyptic pronouncements, which included a reminder that Italy and Belgium could be the next countries in the market's line of fire.
Jean-Claude Juncker told the German daily Sueddeutsche Zeitung that demanding that private creditors contribute to the next Greek bailout package could be considered a "default" by ratings agencies – and that would have extreme consequences for Europe as a whole.
Juncker, the prime minister of Luxembourg who also chairs the 17 eurozone finance ministers, was quoted as saying that a Greek bankruptcy "could prove contagious for Portugal and Ireland, and then also for Belgium and Italy because of their high debt burden, even before Spain."
"We are playing with the fire," he told the paper.
His comments came a day after Moody's warned it may reduce Italy's Aa2 credit rating over concerns about the country's ability to increase growth and reduce its public debt, one of the highest in Europe. The warning followed a similar move by Standard and Poor's, which cut its ratings outlook for Italy's debt from stable to negative.
On Friday, German Chancellor Angela Merkel softened her government's insistence on having private creditors share part of the Greek burden following a meeting with French President Nicolas Sarkozy in Berlin, with both leaders agreeing that the participation should be "voluntary." Ratings agencies as well as the European Central Bank have warned that forcing bond holders to accept losses or give Greece extra years to repay its debt would likely be considered a partial default by Greece that could spread panic on financial markets. Juncker stressed that a debt restructuring would ravage Greek banks, which hold a large amount of their country's debt – some euro80 billion ($114 billion) – ultimately requiring yet another bailout for the banks.
"Everything is becoming yet more expensive because we are including private creditors due to domestic political considerations in Germany," Sueddeutsche Zeitung quoted him as saying.
Indeed, Nostradamus Juncker has a point about Italy. Its debt-to-GDP ratio is actually the euro-zone's second highest after Greece (not just "one of the highest") as the graphic below reveals:
[Click all to enlarge]
Euro area members, estimated debt-to-GDP ratios for 2011. Only five countries are within the limit set by the Maastricht treaty. Italy has the second highest debt-to-GDP ratio after Greece.
In all likelihood Juncker is trying to put additional pressure on the euro-group negotiators to come up with a rescue plan for Greece that is palatable to the financial markets. By waving about the threat of Italy getting into trouble he is likely hoping to concentrate a few minds. As to "playing with fire" – welfare/warfare nations everywhere have been playing with fire for a long time by inexorably increasing their debt burdens over the years. The European currency union has merely helped to bring the problem to the surface by taking away the money printing press from individual nations in the euro area.
Juncker is correct that German domestic politics play a significant and growing role in the troubles the bailout policy is running into. Mrs. Merkel's coalition government is under great strain. Popular support for the bailouts has waned and support for the government coalition has waned right with it.
German politics: The 2009 election result vs. the likely result if an election were held today, according to recent polls. Note that Die Linke (the successor party to the East German communist SED) would get 9% of the vote. In short, leftist authoritarians would today have a 58% majority all told. The by far biggest gains have been enjoyed by the Greens.
Following the Fukujima Daiichi nuclear accident, the conservative/liberal coalition government has essentially adopted the Green party's nuclear phase-out program. This may have done more harm than good to the political standing of the coalition, since it appeared like a yellow-bellied abandonment of its principles in an ad hoc response to an emotionally charged topic. Trying to out-green the Greens was probably a political mistake. Moreover, the government has failed to properly communicate the consequences of the various options of dealing with the euro-area's debt crisis to Germany's population. Within the coalition, firm opposition to Mrs. Merkel's apparent climbdown last Friday regarding private creditor participation in the Greek rescue after her discussions with France's president Sarkozy has immediately flared up.
German coalition government leaders have criticized plans for a voluntary Greek debt rollover agreed to by German Chancellor Angela Merkel and French President Nicolas Sarkozy, arguing that the plan falls short of a full-scale debt restructuring favored by Berlin, German news magazine Der Spiegel reported Saturday.
"This isn't the private sector participation that the German Bundestag pushed for," said Frank Schaeffler, a member of the FDP Free Democratic Party. Manfred Kolbe, a financial expert from Merkel's own CDU Christian Democrats party, called for a haircut on Greek debt, or a reduction in its face value, which "won't be possible under a voluntary basis." Horst Seehofer, head of the CSU, the CDU's Bavarian sister party, said the time had come for private creditors to participate in the Greek debt restructuring.
Berlin has for weeks called for a full-blown Greek debt restructuring by swapping out existing debt for new bonds with longer maturities. But the European Central Bank and other euro-member states have fiercely opposed such a move, fearing it would wreak havoc on financial markets and for banks, especially Greek ones. Merkel agreed Friday to a less-drastic restructuring plan for Greece, through which private creditors can volunteer to roll over their Greek debt holdings.
This certainly sounds as though Mrs. Merkel's apparent agreement with Mr. Sarkozy on the form of private sector participation doesn't enjoy any support within her own government. Her own minister of finance, Wolfgang Schäuble, certainly seems to remain at odds with her newly adopted position. His most recent foray into the debate is a new proposal as to how to rescue the stricken Greek banks in the event that a default is declared. The capital position of Greece's banks is indeed precarious. As we have pointed out many times, these banks would be insolvent by now if not for the funding they receive from the ECB.
Below is a chart published in the Economist last week detailing the hit the Greek banks would suffer to their equity in the event of a 50% haircut to their government bond holdings. It is important to realize that if the banks were to mark their government bond holdings to market, this would actually be the result already, as Greek bonds already trade at 50% and worse discounts to their face value. In short, this chart represents not merely a theoretical outcome – it mirrors the de facto capital position of Greece's banks in accordance with current bond market prices. Furthermore, it is far from certain whether Greece's creditors could really hope for a 50% recovery in the event of a debt restructuring. The pricing of CDS on Greek bonds suggests otherwise (one can infer both default probabilities and likely recoveries from CDS prices).
The equity of Greece's biggest banks before and after a putative 50% haircut on their Greek government debt holdings. In reality, this mirrors their actual capital position as of today, if one were to mark their debt holdings to market.
Mr. Schäuble's latest plan is in the main aiming to make continued funding of the Greek banks palatable to the ECB even after a credit event has been declared. It appears that Schäuble is distancing himself from the voluntary debt rollover plan favored by France and the ECB and recently publicly supported by Mrs. Merkel. Mr. Schäuble certainly espouses the more realistic view – after all, according to the credit rating agencies, a voluntary participation of private sector creditors in the Greek rescue is no longer even considered possible.
Even if the German government were to firmly unite behind the proposal put forward by Merkel and Sarkozy on Friday, i.e., an attempt to construct a private sector debt rollover along the lines of the so-called Vienna initiative (which as it were concerned an entirely different problem, namely the keeping open of credit lines to Western European bank subsidiaries in Eastern Europe), it would still not be clear how this would avert a credit event being declared. Mr. Schäuble at least seems to recognize that the circle can not be squared and offers up some lateral thinking on how to confront the problem. However, his idea basically amounts to adding even more debt atop the existing mountain of debt and the plan appears slightly dubious in that it would treat certain creditors different from the rest.
According to a report in the German news magazine Der Spiegel over the weekend, he proposes the following compromise:
According to plans of his [Schäuble's] ministry, the Greek government will in the framework of the second rescue package not only receive support payments of €90 to €120 billion, but also bonds issued by the European bailout fund EFSF [European Financial Stability Facility]. It is to then hand over these bonds to domestic banks, which could use them as collateral for funding from the ECB.
This is how Schäuble wants to overcome the ECB's objections, which have hitherto hindered a debt waiver by private creditors. The central bank in Frankfurt has always insisted that it could no longer accept Greek government bonds as collateral in this case, as they would receive the lowest possible credit rating if Greece failed to fulfill its payment obligations to the full extent. This consequence, which would cut the Greek banking sector off from funding, could be overcome by such a construction. In order to make it possible for the new bailout fund to provide sufficient funding for further rescue operations, its budget is to be increased so that it can actually mobilize €440 billion, as envisaged when it was established. In order to achieve this, the member nations are to double their guaranties for the EFSF. Germany's share of the guarantees would thus increase from €123 billion to €246 billion.
Schäuble didn't provide any details of how these EFSF bonds would be funded, but presumably they would be added to the Greek government's debt load. So while private creditors would accept a haircut, the government would still be liable in full for the amount of Greek government debt held by the Greek banks, i.e., it would be effectively forced to bail them out. One wonders whether such a construction would survive a court challenge by Greece's remaining creditors – after all, it would amount to declaring the Greek banks a preferred class of creditors. This objection could possibly be overcome by nationalizing the Greek banks, which would be quite ironic, as Greece is about to embark on a big privatization program. So there are certainly some doubts whether this latest proposal will fly.
Vote of Confidence Debate in Greece's Parliament
The debate on the upcoming vote of confidence which prime minister Papandreou's government will be facing on Tuesday has begun. Papandreou has called for this vote of confidence before proceeding with the implementation of the latest austerity package after negotiations between his PASOK party and the main opposition New Democracy party under the leadership of Antonis Samaras last week have failed.
The idea of forming a government of national unity was scuttled again after the opposition demanded that the bailout conditions be renegotiated and Papandreou offer his resignation. It has also become clear that Papandreou is increasingly losing the support of his own party's rank and file. Following the defection of two PASOK backbenchers last week, he has reshuffled his cabinet, replacing finance minister Papaconstantinou with former defense minister Venizelos. Whether this will suffice to give him the required number of votes when the roll-call vote is taken on Tuesday remains to be seen.
Papandreou opened the debate with a call for unity in order to avoid sudden death, as Greece was at a crucial crossroads. Both the smaller parties such as the Coalition of the Radical Left (SYRIZA alliance) under Alexis Tsipras and the main opposition New Democracy party have countered this with a call for new elections. Essentially both opposition groups argue that the Papandreou government has lost popular support and they will therefore refrain from giving it a vote of confidence.
As Antonis Samaras put it in conclusion to his speech:
We will not destabilize the country. It has been destabilized enough by the government. We do not want to govern ruins tomorrow. We are not the same as PASOK. Regardless of the outcome of the vote of confidence, the government has permanently lost the confidence of the people. That is irreversible.
In short, the government's survival now hinges mainly on Papandreou's ability to convince his own party members to vote for him on Tuesday. With a razor-thin four vote majority in parliament after the recent defections it is far from certain that he will secure sufficient support.
One of Papandreou's problems is the growing "indignant movement" as the protesters in Athens' Syntagma Square are referred to. The images of the increasingly violent demonstrations have produced a shock wave that has reverberated around the world last week.
If Papandreou's government survives the vote of confidence and gets to implement the latest batch of austerity measures negotiated with IMF, EU and ECB (the troika of public sector creditors), the can will likely be kicked down the road one more time. As the chart below shows, buying time has so far not had any positive effect. It has instead led to the digging of an ever bigger hole, just as we already suspected over a year ago, when we first wrote about the debt crisis in these pages.
The Greek dilemma, via Der Spiegel. As the economy contracts, the government's cumulative debt continues to bound higher.
Private vs. official creditors of the bailed out trio of nations, via Goldman Sachs. The public sector is taking on an ever larger share of the outstanding debt.
The maturity profile of Greece's public debt, in billions of euro. 2011 is from May 5 onward (source: Der Spiegel, Bloomberg).
The Contagion Goblin
In spite of JC Juncker pointing to the risk posed by Italy and Belgium, which stems from the sheer size of their respective government debts relative to their economic output (as an aside to this, government debt to GDP ratios do not tell the whole story, as tax revenues, private debts and savings, the health of the banks, the value of state-owned assets, etc. all have to be considered in such a risk assessment as well), we continue to believe that Spain poses the greater risk in terms of contagion potential. While Spain still sports a relatively low government debt to GDP ratio (if a fast growing one), it has very grave economic problems. Property busts following major bubbles are always especially difficult to go through, as real estate bubbles tend to create malinvestment on a very large scale and tend to leave enormous amounts of unsound credit behind when they burst. Zombified banking systems and high unemployment rates are usually their legacy. The unemployment rate in Spain has clocked in above 20% for quite some time, with youth unemployment more than twice as high. Obviously this is a socially very explosive situation – and the government has few means to mitigate it, given its austerity mandate. Spain's saving grace is that its wage rates are more competitive in the euro area context than those of Greece, Portugal and Ireland, but on the other hand the country has an extremely high external debt load after years of running large current account deficits.
The markets also tend to take a dimmer view of Spain's government bonds than those of both Italy and Belgium. Italy's 10 year government bond yield reached a high of just above 5% in March and now trades at 4.82% – still uncomfortably high, but there is no breakout in evidence yet. Belgium's 10-year government bond yield traded as high as 4.39% in March and currently resides at 4.12%. These yields are worryingly high compared to Germany's current 10-year yield of 2.96%, but it can not be said that they trade at an excessive risk premium. By contrast, the current 5.57% yield on Spain's 10-year bond represents a test of the recent breakout to an 11-year high and clearly gives more cause to worry. A similar difference is visible in the CDS spreads on the debt of these three countries – Spain's trade at a much higher level than both Italy's and Belgium's. As assessments of relative risk go, we would rather go with the market's than Mr. Juncker's.
A weekly chart of Spain's 10-year bond yield showing its path since 2005. Note that up until late 2009, this yield tended to closely mimic the yield on comparable German government bonds – it only began to diverge in early 2010, during the first iteration of the euro area debt crisis. This strikes us at the moment as the by far most worrisome chart in the world.
From a technical perspective, the breakout from the recent consolidation points to a near term target of 7.5% for Spain's 10-year government bond yield. That would be approximately the height at which Ireland and Portugal became wards of the EFSF, so this is clearly a chart that should keep the eurocrats awake at night.
This is not to say that Italy and Belgium do not harbor great risk as well, but clearly Spain is next in line, especially if the Greek crisis fails to abate. Not only that, but Spain's own recent economic data releases have been less than comforting. Last week we mentioned the new high in bank loan delinquencies in Spain, but it helps to look at a chart in order to visualize it in the historical context.
Spain's bank loans, the percentage that is 90 days + delinquent, as of the end of April 2011 (this is the most recent datum available). These delinquent loans amount to €115.4 billion at present - the highest ever and clearly not a trivial amount.
The Bank of Spain's estimates earlier this year as to the additional capital likely required by Spain's banks (worst case €20 billion, as opposed to Fitch's estimate of €100 billion) seem rather understated in light of this – not least because of what these data are not revealing. Spain's banks and cajas use numerous accounting tricks to sweep non-performing loans under the rug, so the fact that the official figure has increased to such a staggering amount should be of great concern. Clearly this has implications for Spain's government finances, given the ongoing effort to clean up the mess that especially the cajas find themselves in. Bigger banks with a large international presence such as Banco Santander have their share of problems as well, but their international business helps to mitigate the troubles they encounter in Spain.
Nevertheless, the market remains skeptical even of these banks, which have trade very similar to major bank stocks in the US over the past 18 months.
A weekly chart of Banco Santander shows a descending triangle has developed since the post 2008 crash rebound high that was achieved in early 2010. It is possible that this will eventually turn out to have been an extended correction, but a break of support just above the €7 level would obviously be a bad sign.
Spain's government debt maturities in billions of € (2011 from May 5 onward – source: Der Spiegel, Bloomberg). Redemptions will be at their highest in 2011 and 2012.
Is the ECB's Policy Appropriate?
This is actually a bit of a trick question. No central bank has ever an appropriate policy, since the policy of a central economic planning agency that fixes interest rates will always be sub-optimal compared to a free market outcome. In the ECB's case we merely note that its recent policy has been quite tight – which is probably the main reason why the euro has remained fairly firm in spite of the recently once again escalating sovereign debt crisis. The ECB's balance sheet has contracted by about 10% over the past year and the growth of money supply TMS in the euro area has begun to stall out markedly, with the quarterly annualized growth falling to just 1% and the 12 month growth rate clocking in at a very subdued 2%.
There is nothing wrong with the central bank being tight, as this will minimize bubble activities in the economy, i.e., activities that depend solely on easy money and ultimately consume scarce capital. However, from the point of view of the highly indebted and uncompetitive peripheral sovereigns it no doubt makes life more difficult in the short term, as they cannot hope for relief from a lower euro exchange rate. Not surprisingly, the first iteration of the debt crisis became acute shortly after the ECB had contracted central bank credit in the second half of 2009. The intermittent bouts of euro selling we have witnessed in recent weeks happen probably in anticipation of a policy reversal.
The yearly growth rate of the asset side of the ECB's balance sheet is contracting sharply.
Euro area TMS ("true money supply") via Michael Pollaro. Both the annual and the quarterly annualized growth rate have declined sharply. In spite of the fact that the ECB's administered interest rate is at only 1.25%, money supply growth is stalling out.
The euro area overall is in an analogous situation to the US, insofar as whenever the central bank ceases to actively pump up the money supply, the still ongoing private sector credit contraction takes over and exerts a deflationary pull. For instance, in Spain total bank credit outstanding has fallen back to the level of mid-2008. In a fractionally reserved system, outstanding deposit liabilities, i.e., perfect money substitutes, tend to decline during economic busts if more credit is paid back then is extended.
Usually the central bank will reflate by means of lowering the administered interest rate, but once the economy's pool of real funding is stagnating or even shrinking, it becomes impossible to thereby create an appreciable effect on credit growth and economic activity. Any attempt to postpone the necessary economic adjustments in an effort to avert short term economic pain via monetary pumping is of course ultimately condemned to lead to an even bigger bust.
As far as the fractionally reserved central bank-led fiat money system goes, our only recommendation remains that it should be abolished as quickly as possible and replaced with free banking and a free market based monetary system. But this is a recommendation that meets with the disapproval of current economic orthodoxy and moreover implies a reversal in the growth of the state, which is the exact opposite of the current political reality. This leaves us only to observe and analyze the developing situation as best as we can. If the debt crisis intensifies further, it seems likely that the ECB will eventually reverse course and once again adopt an easier stance.
CDS on Greek government debt literally went vertical last week, with the five-year CDS spread landing at an astonishing 2,234 basis points – by far the highest CDS spread on sovereign debt in the world. It now costs $2.234 million per year to insure $10 million of Greek government debt over a five-year period – i.e., over the entire time horizon it would cost more to insure the debt than its face value amounts to. Evidently the market expectation is for the default to occur well before five years have passed.
The only positive we can glean from this development is that it reflects an inordinate amount of fear by market participants. Often – but by no means always – such a panic is a short term contrary indicator. It needs to be noted that the extremely high default probability expressed by the CDS market is not yet fully reflected in so-called risk assets, which continue to levitate on a cushion of hope. CDS prices in basis points, color coded:
Five-year CDS spreads on Portugal, Italy, Greece and Spain – all of them have been rising, but the Greek ones have gone parabolic last week. Portugal ended the week just below a new high, and CDS on Spain's government debt briefly peeked above the 300 basis point level for the first time since January.
Five-year CDS spreads on Austria, Hungary, Bulgaria and Romania – bouncing, but still tame. We want to keep an eye on the latter two due to their indirect exposure to the Greek debt crisis via Greek bank subsidiaries operating in these countries. This risk may not be properly appreciated at the moment. In Bulgaria the Greek banks hold credit claims amounting to 27.5% of the total credit outstanding in the economy.
Five-year CDS on Ireland, France, Belgium and Japan. All trending higher last week with gusto, with Ireland hitting a new all time high on Thursday.
The Markit SovX index of CDS on 19 Western European sovereigns. After clocking a fresh all time high on Thursday, it pulls back on Friday following news that Germany and France have agreed on a way forward regarding private creditor haircuts. The index has lately become overbought, indicating that a short term correction may be in the cards – but it continues to look bullish to us on a medium term basis.
One-year euro basis swap – still no major move, but anything below the zero line is not normal compared to the pre-crisis period.
Five-year euro basis swap – once again moving in the wrong direction.
The Greek two-year government note yield ends the week at a record high of 31.67%. In October 2010 this yield briefly dipped into single digit territory.
Charts by: Goldman Sachs, Der Spiegel, Bloomberg, European Commission, StockCharts.com, Michael Pollaro.