FYI | Jul 11 2011
– Investors bail out of Italy, fearing implosion
– Spain cops the brunt of the ECB rate rise
– Germany proposes new Greek solution
By Greg Peel
“Pretending that this is just a liquidity crisis will no longer wash. What it will take is a belated recognition by Germany that this crisis is not a morality tale contrasting virtuous, thrifty Teutons with feckless Greco-Latins and Guinness-befuddled Celts but rather a North-South structural crisis caused by the inherent workings of monetary union.”
London Financial Times commentator Ambrose Evans-Pritchard has long been a critic of an ill-conceived eurozone. Germany continues to be reluctant to commit taxpayers funds to bailing out peripheral eurozone economies given their fiscal recklessness as Evans-Pritchard alludes to above. Germany also wants private sector holders of peripheral debt to share in the cost of bail-out, which is a reasonable expectation but has potentially dire ramifications for European financial markets.
Evans-Pritchard is also no fan of the current European Central Bank leadership. The ECB raised its cash rate last week for the second time since the GFC in an effort to attack rising inflation driven by northern eurozone GDP growth, particularly that of Germany. In so doing, the ECB is claiming it can deal with two crises at once – being inflation problems on the one hand and emergency issues regarding peripheral debt on the other – even though policy responses for both are diametrically opposed.
Spain has suffered an extensive property market bust through the credit crisis and GFC, yet by raising its cash rate the ECB is raising the cost of 90% of Spanish mortgages. And where, exactly, is this inflation, Evans-Pritchard asks. Annualised growth in eurozone M1 money supply has fallen from 2.9% in March to 1.2% in May. Broader M3 money supply has grown at only 2.2% over the past three months. In the meantime the Spanish and Italian manufacturing PMIs have fallen into contraction.
According to the IMF, the GDP of Germany was US$3.3trn in 2010 placing it fourth in the world. France (5) came in at US$2.5trn while Greece (32) posted US$305bn, Portugal (38) US$229bn and Ireland (43) US$204bn. Because of the small size of the peripheral economies, many in the market believe there is little to fear from their demise. The collective E273bn of bail-out funds announced to date is minor compared to the full financial resources of the eurozone. But Spain (12) at US$1.4trn and Italy (8) at US$2.1trn are a different matter. As a comparison, Australia (13) slots in behind Spain with US$1.2trn.
The issue is not just one of contagion stemming from a Greek default, even though the potential for a Greek default never seems to go away. Spanish mortgages are one thing, but the world has become very concerned over current developments in Italy.
Tonight EU officials will gather for a crisis meeting in Brussels. They are not calling it a crisis meeting, and reject such a notion, given it is a rescheduled meeting to discuss the proposed 2012 Greek bail-out package and this year's stress tests for European banks. But everyone else is calling it a crisis meeting, with Italy now the primary focus. The officials have insisted Italy is not even on the agenda, but no one believes them.
On Friday, Italian stocks and bonds suffered a significant sell-down. Bank stocks were hardest hit, with Unicredit, Italy's biggest bank, falling 8%. Investors are worried Italian banks may fail this year's round of stress tests which are due for release on July 15 – a fear dismissed by the Italian central bank. The yield on the Italian ten-year bond blew out to 5.28%, edging towards the 5.5-5.7% level beyond which economists suggest Italy would struggle to refinance itself. But Italy's problems are political as well as financial.
Italian prime minister Silvio Berlusconi has ignited a public slanging match with his own finance minister, Guilio Tremonti. The two have disagreed before over austerity packages and tax cuts but Tremonti is held in high regard by global bond traders as a steady hand on the tiller of a ship in stormy seas. Yet on Friday, Berlusconi suggested publicly that Tremonti “is not a team player, and thinks he's a genius and that everybody else is a cretin”.
Imagine Julia Gillard saying that of Wayne Swan, or even Tony Abbot saying that of Joe Hockey. It is little wonder global investors decided Friday was a good day to exit a foundering ship. To make matters worse, Tremonti has been indirectly accused of corruption because he has been living free in a flat owned by a political ally who is up on corruption charges. Resignation rumours are circling, and the Italian press is more than bemused.
“The government ceased to exist months ago,” suggested La Republica, “What other country would allow itself the suicidal luxury of offering cynical markets such a spectacle of political disintegration and institutional decay at a time when Europe is destabilized by Greece's sovereign debt and haunted by contagion?”
Suggestions are growing that eurozone officials are going to have to stop simply fiddling around the edges with Greek bail-outs and start thinking “shock and awe” monetary tactics. The expression arose in late 2007 when the Fed responded to the growing credit crisis with a full 50 basis point cash rate cut. The Fed then had to “shock and awe” more than once, including a 75 point cut in 2008. The ECB's initial response to a growing global credit crisis was to increase its cash rate by 25 points to combat the inflationary impact of soaring oil prices. That move took the ECB rate from 4.0% to 4.25% but pretty soon the ECB was forced to slash down to 1.0% following the GFC.
Such history puts last week's ECB hike to 1.50% from 1.25% in perspective.
If it were up to Evans-Pritchard, rather than raising rates the ECB would provide “half a decade of super-easy money” to weaken the overvalued euro and stave off debt deflation. “Without either, Italy and Spain can only pray for a miracle.”
Italian GDP has not grown for a decade, notes Evans-Pritchard. Official forecasts suggest 1.1% GDP growth in 2011 but outside forecasts are much weaker. Jefferies Fixed Income has suggested the elephant in the room of the European debt crisis is that Italy's debt payments will explode within three or four years if the average borrowing cost increases by 200-300 basis points. The ten-year yield has pushed up to only 5.3% so far but that's how it started in Greece, which now has two-year bond yield in excess of 20%.
Which brings us to Greece's second bail-out package – the supposed subject of tonight's meeting in Brussels. EU officials have put off and put off a decision on the package, first waiting to see what would transpire from the drama of last week's Greek parliamentary vote with regard to the current package. The reality is that Europe is no closer to an agreement than it ever was.
Germany, the Netherlands, Austria and Finland are all determined, notes Reuters, that banks, insurers, and other private holders of Greek government bonds should bear some of the cost of helping Athens. But the constant stumbling block of “haircut” solutions is that ratings agencies believe they would effectively be a form of default, and the ECB rules do not allow defaulted debt to be held as collateral. At present the ECB is holding Greek debt in exchange for emergency loans.
French banks got together recently and offered up a complex solution that would involve rolling over Greek debt into new thirty-year bonds. Critics have suggested the plan is self-serving and will only add to total Greek debt levels over time. The plan was rejected by Germany, but a German-led consortium of creditor countries has now come up with its own solution.
The Financial Times reports the new strategy, which will be discussed at the meeting tonight, would involve Athens defaulting on part of its debt in return for new bail-out concessions including lower interest rates on loans and a broad-based bond buyback program. The idea is to have both the public and private European sectors taking some of the pain in order to reduce Greece's debt burden. Details are not expected to be agreed upon for another month or so, but the FT's take is that if the strategy were agreed, “it would mark a significant shift in the 18-month struggle to contain eurozone debt”.
The strategy was originally devised by German investors, including Deutsche Bank, and could see private holders buying back as much as 10% of outstanding Greek debt. Given that debt is currently trading below face value, such a buyback would constitute a “haircut” on investments.
The buyback would have to be funded, but the European Commission has long been pushing for the recently agreed upon E440bn eurozone general emergency fund to be used for such a strategy. Funnily enough, the proposal has to date been rejected by Berlin.
So we may now have some progress on the Greek front, as Italy threatens to implode and Spain cops the pain of an ECB rate hike. One assumes that a buyback for a loss, rather than a restructuring as the French banks had offered, would not imply a technical default in the eyes of the ratings agencies, although an EC funded collective buyback may still be deemed a “distress” response and thus a partial default.
Tonight's meeting will indeed be interesting.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.
