Wednesday, December 7, 2011

The EU summit will fail

This week’s EU summit meeting will fail. The purpose of the meeting is to agree to a fiscal stability plan that will persuade the ECB to rescue Italy and Spain. This will fail for two reasons.

First, there is considerable daylight between what Germany wants and what the EU or the  eurozone can agree to. Germany wants a new treaty with binding constraints. A new treaty requires all 27 countries to sign on because every country has a veto. A number of EU countries that are not in the eurozone lack enthusiasm for this idea. It is unclear if European law contemplates a treaty that leaves out a number of members. There could be a eurozne-only agreement, but not a treaty. It is hard to see how the leaders can emerge on Saturday with anything like what Merkel wants.

Second, there is little reason to believe that there is anything that can persuade the Bundesbank to reverse its position on rescuing Italy and Spain. While Draghi has made hopeful noises, the president of the Bundesbank, Jens Weidmann, has not. His position is that this is a matter for the EU to solve via eurobonds, which Merkel has ruled out. Draghi cannot rescue Italy and Spain without the Bundesbank’s consent.

It will be interesting to see how the leaders, who are staring into the abyss, can construct a communique that will obscure the summit’s failure. 
Many European leaders have said that a failure to rescue Italy and Spain will lead to catastrophe. But standing in their way is Germany, which won’t agree to guarantee other countries’ debt, and the Bundesbank, which will not allow the Bundesbank to become the eurozone’s bond buyer of last resort. 
Without either eurobonds or an ECB rescue, Italy and Spain are doomed.

In the event of their default and/or redenomination, the rest of Europe will have to recapitalize their banks. This will place strains on everyone, especially France and Germany. In the end, I would expect the ECB to capitulate and embark upon an unprecedented campaign of quantitative easing.

Should it fail to capitulate (soon), the outlook for the eurozone is dire. Those of us outside the eurozone (UK, Canada, US, Australia, Japan) will be able to lean against the deflationary forces blowing over from Europe.

The major economy most at risk now, besides Italy and Spain, is France. France may lose its AAA, will have to bailout its banks, and will have to remain credible in the bond market. This will force a level of austerity that could lead to civil unrest.

Thursday, December 1, 2011

Draghi's speech to the European Parliament: a breakthrough?

Mario Draghi, head of the ECB, gave a somewhat dovish speech today to the European parliament. As the NYT reports:

He seemed to be saying that the bank would use its virtually unlimited resources to keep financial markets at bay, if government leaders in the euro region agreed to do their part by addressing the structural flaws that had allowed the debt problems of Greece to mutate into a threat to the global economy.

“What I believe our economic and monetary union needs is a new fiscal compact,” Mr. Draghi said. “It is time to adapt the euro area design with a set of institutions, rules and processes that is commensurate with the requirements of monetary union.” After government leaders take steps to improve the way the euro area is managed, “other elements might follow,” Mr. Draghi said.

I can’t imagine Draghi would make such a statement without the consent of the ECB’s governing board, including the Bundesbankers. He seemed to be saying that if the “Merkel Plan” is adopted, the ECB would intervene more forcefully in the government bond market.

The Merkel Plan would change the eurozone from a monetary union into a fiscal union, with Brussels in charge of national fiscal policy. It has not yet been fully embraced by Sarkozy, and it leaves unanswered what would happen to the 10 EU members who are not part of the eurozone.

I won’t say that the ECB’s independence has been compromised de jure, because it certainly hasn’t. But the ECB has found itself in the awkward position of either leaving its “price stability” comfort zone, or else standing by while the eurozone (its raisson d’etre) goes away. It would be understandable if certain board members did not wish to preside over the dissolution of the eurozone.

“Who will rescue the eurozone?” is a hot potato that has been tossed back and forth between the ECB and the eurozone governments for a number of weeks. It would seem that they have begun to inch toward a joint plan:
the eurozone will impose a fiscal strait-jacket upon itself, in return for which the ECB will intervene forcefully in the bond market, thus rescuing Italy and Spain.

There are two big ifs here: (1) Will all 17 members agree to the Merkel Plan; and (2) if they do, can Draghi really deliver the ECB in force? Previously, the ECB had demanded that the eurozone issue guaranteed eurobonds. Now it would appear that it is prepared to buy national bonds without any guarantees on the basis of the “fiscal pact”. As always, I am skeptical. But this latest news suggests that all is not yet lost, and there may indeed be light at the end of the tunnel.

If so, this is very bullish news, the best news in months if not years.

France should ring-fence its banks now

There are two ways that Italy and Spain can be rescued from collapse: either the eurozone agrees to issue eurobonds which are guaranteed on a joint-and-several basis by all 17 members, which would be used to refinance maturing debt; or the ECB agrees to act as bond buyer of last resort and establishes a standing bid for Italian and Spanish bonds at an agreed yield.

If either of these events occur, Italy and Spain will be able to continue to repay maturing debt. If neither of these events occur, then at some point the bond market will close to Italy and Spain, as it did to Greece. (The bond market may have already closed, since the ECB does not disclose its purchases by individual country.)

Under the bad scenario, Italy and Spain will have to restructure their debt and/or leave the euro. Either way, banks will be faced with substantial writedowns.

Which brings us to France. France is a strong credit (somewhere in the AA category) despite its banking system’s exposures to Italy and Spain. Its banks, however, are not strong credits on a standalone basis, because of their eurozone exposures as well as general unprofitability.

The weakness of France’s banks (especially BNP) is contaminating France’s own credit, such that France is having to pay yields as much as 2% above Germany. It is time for France to bailout its banks, and thus demonstrate its ability to withstand defaults by Italy and Spain.

There are a number of ways for France to bailout its banks, but here is a pretty common method: Establish a state owned entity (or use an existing state institution such as CDC) to buy marketable assets (i.e., sovereign bonds) at current market prices (below their current accounting value) and make up the losses with new equity. That way, the banks would no longer be at risk of further writedowns on this paper, and should thus regain their credibility in the debt market. There is much less of a problem with exposures to Italian and Spanish banks; these are manageable and declining, with the ECB taking up the slack.

For reasons that I can’t fully understand, the rating agencies have said that if France incurs additional indebtedness in order to bailout its banks, it is likely to lose its AAA rating. Since these costs are known contingent liabilities, this threat suggests that the agencies are using mechanical debt ratios, as opposed to taking into account contingent liabilities. This is particularly peculiar for S&P, which has been saying for over a decade that it takes into account the contingent liability posed by the banking system when analyzing sovereigns.

In any case, France has already lost its AAA in the bond market, partly in anticipation of a downgrade, and partly due to the weakness of its banks. In my opinion, France should bite the bullet now, take the downgrade, and move on. This would give the bond market one less thing to worry about.