Wednesday, December 8, 2010

The London Brief

By Omar Sayed

The Cypriot banking system holds assets that are seven times Cyprus’ GDP. While the system is almost one hundred percent deposit funded, over one third of these deposits are foreign, mostly from Greeks trying to hide or protect savings by moving them out of Greek banks. Cyprus banks hold €5 billion of Greek government bonds. If the bonds received a 30% haircut, the banks Tier I capital would be gone. Most of the Cyprus bank loan books are to Greeks and non-performing loans are edging sharply upward as a result of the austerity programs.

Cyprus’ GDP is only $25 billion, a drop in the fiat money printing ocean. But it’s indicative of a major problem governments don’t have the tools to solve: volatile and sudden capital flows. Greeks worry about their banking system and rapidly transfer deposits to Cyprus creating a banking system that is larger than the state’s ability to support in a crisis. Then as a shock hits the banking system, the capital flows violently flow somewhere else creating a new banking crisis.

European Crisis

An unidentified banker in the Financial Times said, “The ECB needs to use the bazooka option to lift sentiment in a lasting way. That is the only way to stop this crisis from spreading. We had a good day today, but yields are only coming down because the ECB is buying. It has got to continue doing so and in size.” Considering many of the banks are the ones selling sovereign bonds to the ECB for profit, I can understand the banker’s sentiment. But is ECB bond purchases a real solution?

CDS trading in Irish debt saw opening prints compress with the five year CDS trading at 275/295 and the ten year at 215/235. Within minutes they were back trading 575/595 and 515/535 respectively. A few hours later, they were flat to Friday’s close and Portugal was widening. It wasn’t until later in the week when the ECB stepped in with €100 million per clip in Irish and Portuguese bond purchases that spreads narrowed.

The market realizes the European sovereign crisis is still not solved. There is wide sentiment that the EU may disintegrate and the euro is a short.

Yet European disintegration is practically unfeasible. For instance, if Ireland were to pull out of the euro, they would have to force conversion on depositors so that bank assets could match liabilities. Ireland would have to reintroduce capital controls to prevent people from sending their money overseas. They might even have to restrict foreign travel or check briefcases at the airports. There would be caps on bank withdrawals.

It would be a nightmare for Germany too. Germany’s exporters would instantly lose competitiveness and customers. Germany is the EU’s largest creditor and it would see its investments outside Germany sharply decline in value. Monetary policy would be in disarray. German banks and pension funds would be in trouble.

So in order to preserve this unholy union, what options does the EU have? I see four: (1) the Marshall Plan II; (2) the Treaty of Versailles II; (3) the printing press option and (4) the Icelandic option. Each has its challenges and problems.

The first option is the most politically sensitive, but potentially the most effective. Currently the EU’s program can support Portugal, Greece and Ireland, but is too small for Spain and Italy. Under this option, the EU boosts the size of the rescue fund or turns it into an asset buying program where they buy sovereign bonds. The EU can also float its own euro-bonds for the periphery or make guarantees that periphery debt is EU debt. They can cut interest on loans to help states better balance budgets. The EU could also lighten up on austerity and take a more active role in fiscal programs and auditing. Then focus on fixing the periphery’s lack of export competitiveness. The EU is sitting on billions of unspent redevelopment funds that could be channelled into projects. For instance, Greece has certain off-shore power projects that could provide energy for the whole EU but also jobs for Greeks. Port redevelopment is a major growth initiative from goods coming from the Middle East and Africa. The rigidities in the Greek system that make it more expensive to move goods around internally than externally could be reformed under a crisis pretext. Companies like Siemens could be incentivized to build a factory in Portugal or Ireland. The idea is that rather than make periphery nations deflate, you help them grow and pay their way out of debt.

Political sentiment in Germany in favour of this option is changing because the country is having a good crisis. GDP grew by 3.5% this year and is expected to grow 2% in 2011. Retail sales jumped 2.3% in October suggesting rising domestic demand. Half of Germans now support the Greek bail-out according to an Economist poll versus 20 per cent in April.

For EU integrationists, this could be a dream come true, a way to homogenize fiscal accounts and assume greater EU sovereignty over individual states.

The challenges though are execution, the willingness of states to allow the EU to assume fiscal responsibilities, the willingness of northern Europeans to make rival nations more competitive and implementing projects that would take many years before seeing results.

Currently, the EU is adopting the Treaty of Versailles II option. This option entails an internal devaluation or lowering wages to regain export competitiveness. However, this doesn’t work because you are not making capital cheaper. Debt to GDP gets larger until a frustrated Irish or Greek public elect politicians to take actions to break their slavery through default.

The third option is to get the ECB to keep buying sovereign bonds while the EU works on a way to help Ireland, Greece and Portugal balance their budget so they don’t need to issue more bonds. The ECB can keep monetizing the debt and hope the problem gradually goes away. The problem is that Spain and potentially Italy are deflating; therefore the problem will not go away. Also the euro would decline leading to the potential for significant inflation. My commodity basket is pushing its highs. At some point debt monetization becomes suicidal.

Finally, there is the Icelandic option. This involves restructuring the debt and making bond-holders share losses. Already there are discussions taking place about a managed default where deposits and payment systems would be transported into a “good bank”. Bank loan books would be excised and the bank would be infused with new capital through “bail-in” procedures, where bond-holders receive equity. A mechanism would be necessary to manage cross-border banks. Such a program would trigger an instant sell-off in other nations such as Spain, Italy and Belgium and potentially force debt restructurings there too (the contagion effect). Also the losses from such restructurings could end up creating a Lehman like effect through the shadow banking system, which still exists and is difficult to measure. This strikes me as the second best solution if a Marshall Plan option is unfeasible.

The Marshall Plan II is quite possible given the IMF’s (ie – America) willingness to give more money to help Europe. But I am doubtful that this is the path that is chosen. Many northern Europeans have adopted the same approach as the French and British did after World War I and want to make the periphery suffer in a bout of self righteousness. I can understand the sentiment and it can be done to a limited extent, but they will force the people to rebel against austerity. At that point, the whole experiment unravels. If the EU wants its venture to succeed, they have to think growth and restructuring, not austerity.

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