Over the weekend both Greece and Italy replaced their leaders and formed new governments, all without elections. In Greece Lucas Papademos has taken the reins and in Italy Mario Monti has been given the top job by the President. Both men face an uphill battle to turn their country’s economies around. Given the circumstances in which the new governments were formed, I had hoped that the rest of Europe would get behind them and renegotiate new plans. However initial reports suggest that nothing has changed:
Greece’s new prime minister Lucas Papademos has held urgent talks with French President Nicolas Sarkozy and German Chancellor Angela Merkel on the bailout for his debt-hit country.
Both Sarkozy and Merkel underlined the need for Greece to implement the measures it had agreed to in return for the next instalment of an international loan, a statement from Sarkozy’s office said after Saturday’s talks.
“The payment of the next tranche (of the bailout) can only take place when a decisive step has been taken in this matter.”
In separate talks, the French and German leaders “reaffirmed their determination to totally defend the euro”, the statement added.
Equities markets seem happy with the news of a new governments, and I have no doubt that will continue for a short period of time. It seems, however, that other markets are far less subdued.
As I have said many times over the last month or so, the politics of European nations is a side show to the economic issues of Europe. The response to Papademos from Merkozy tells me that very little is about to change in that regard. But I guess I shouldn’t be surprised, the European bureaucracies along with the IMF have been misdiagnosing their issues for well over two years now, why would the changing of the guard in Greece and Italy make any difference ?
Europe’s solution all through this crisis has been to force austerity on deficit nations in what seemed to be the misguided belief this would stem the crisis. As George Magnus from UBS explained last week this was:
.. conventional but misguided economic thinking, which has deep historical roots, holds that rebalancing should occur via strong deflationary adjustment in debtor countries. This is to seriously misunderstand the problem, and to exacerbate it. Not all countries can or should become creditors or save more simultaneously, and the burden of adjustment and responsibility to act should fall more equally on creditors. If the burden of adjustment falls wholly, and often harshly, on debtor nations, global output and employment will again weaken or contract, and social and financial instability, and banking sector and sovereign stress will intensify. The gravity of the situation in the Eurozone, in particular, is apparent as the crisis permeates into the core of the monetary union, and threatens it existentially.
This misdiagnosis has been highlighted by the failure of policy in Greece which, as I first mentioned over a year ago, will continue to fumble from one crisis to another because this core issue has not been addressed. Again from George Magnus:
The recently leaked ‘troika’ report on Greece makes the candid admission that what is euphemistically called ‘expansionary fiscal contraction’ has failed and that there is a deep contradiction between internal devaluation and maintaining a fixed exchange rate. Put another way, austerity has made things worse, and may actually be inappropriate on its own as a way for Europe to stabilize sovereign solvency. This is a big admission – that hasn’t yet permeated the minds of European leaders.
The failure to fully grasp the fact that their cure was actually making the disease worse has also left European leaders stumbling from one crisis to another. The latest attempt to stop the contagion concluded with the release of a new 3-part plan when the leaders met in late October. The trouble is that once again this plan was ill-conceived and now, just like initial actions around Greece, is having unexpected negative consequences.
The first part of the plan, bank recapitalization, was aimed at strengthening the banking system by forcing the banks to reach a capital ratio of 9% against risk weighted asset by using private markets as a primary source , national governments as the secondary source and, if all else fails, the EFSF. Given that markets were already in a distressed state at the time of the agreement, it should have been obvious that private markets were not going to provide this capital. It is also quite simple to pick holes in a plan where the balance sheets of nations already under stress are loaded up with paper from their banks which are exposed to those same governments. In many circumstances it isn’t just the banks that require new capital but the governments themselves and a shift of debt from one balance sheet to another has little overall effect. What is needed for many of these nations in the short term is external capital, which in respect to Europe at present means the EFSF. I will come back to that issue shortly.
What has actually happened, however, is that the banks have shown little interested in using any of these options in order to meet their new capital requirements. They are not interested in having their institutions diluted by new equity issuances or to hand over any control to governments. Instead banks have been “playing” this request in two ways. Firstly they have simply adjusted their internal risk models. No this is not a joke:
Banks in Europe are undercutting regulators’ demands that they boost capital by declaring assets they hold less risky today than they were yesterday.
Banco Santander SA (SAN), Spain’s largest lender, and Banco Bilbao Vizcaya Argentaria SA (BBVA), the second-biggest, say they can go halfway to adding 13.6 billion euros ($18.8 billion) of capital by changing how they calculate risk-weightings, the probability of default lenders assign to loans, mortgages and derivatives. The practice, known as “risk-weighted asset optimization,” allows banks to boost capital ratios without cutting lending, selling assets or tapping shareholders.
And secondly they have stated that they will shrink their existing asset base and slow new credit issuance to meet the target. Slower lending will obviously have a negative effect on the real economy across Europe making the situation worse, but what is also happening is a drain of liquidity from regions of Europe that are serviced by subsidiaries of major banks from larger nations. Slovenia is one such nation and the outcome has been swift and punishing:
Yields on the 10 year bond breached 7 per cent on Friday morning before falling back to 6.97 per cent in the early afternoon.
…
“The initial trigger was the Italian crisis. Italian bank subsidiaries have been very active within Slovenia. Those banks went on a lending binge during the boom years” between 2006 and 2008. The concern now is that, as Italian banks suffer funding problems at home, they will have to pull in their horns, triggering a liquidity crisis in Slovenia.
A secondary problem with the October plan is the EFSF itself. The stability facility is supposed to provide emergency funding to distressed European nations and, as I mentioned above, be the final backstop for banks recapitalisations. As I explained previously the EFSF is not a credible lender of last resort because it must seek funds itself before they can be used and it is built on a structure in which the same nations that require emergency funding due to their failing economies are the ones supposedly providing the underlying collateral to support the facility. Obviously the fact that the negotiation of a 50% write-down on Greek debt did not trigger a credit event has made the market weary of European sovereign backed insurance, but even without that issue the EFSF does not have enough initial fire power to save Europe.
Over the last few weeks we have seen the EFSF’s credibility slowly wither as one after another external capital providers have stated that they either will not or cannot provide support for the facility. The credibility of the EFSF now seems to be collapsing with a report in the Telegraph UK over the weekend that it was forced to buy its own debt:
The European Financial Stability Facility (EFSF) last week announced it had successfully sold a €3bn 10-year bond in support of Ireland. However, The Sunday Telegraph can reveal that target was only met after the EFSF resorted to buying up several hundred million euros worth of the bonds.
Sources said the EFSF had spent more than € 100m buying up its own bonds to help it achieve its funding target after the banks leading the deal were only able to find about €2.7bn of outside demand for the debt.
….
Other European Union funds are also understood to have supported the EFSF’s bond sale.
This report has now been denied by the EFSF, but I suspect the damage is done. Without some last minute buy-in from a credible source of capital the facility looks to have lost the faith of the market.
Greece and Italy now have new governments, but the crisis is just beginning.