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By Ambrose Evans-Pritchard | 30 May 2010
The downgrade could not have come at a more dreadful moment. The EU's €750bn "shield" for eurozone debtors has halted an incipient run on Club Med banks, but it has failed to restore full confidence for the obvious reason that such a guarantee cannot plausibly be extended from Greece to Portugal and then to Spain. The sums are too large, the number of solvent creditors too reduced, the intra-EMU politics too poisonous.
Pierre Lellouche, France's Europe minister, compares the shield to NATO's Article 4, the mutual defence clause that deems an attack on any one state to be an attack on all. Leaving aside the question of whether NATO's Article 4 was ever credible— I doubt it was— this use of NATO language illustrates the confusion in EU circles over the causes of the Club Med bond crisis. This is not a war. It is a beauty contest. Eurozone states must attract capital from pension funds and Asian central banks to finance their deficits— or default.
Whether intended or not, Mr Lellouche may have pulled the detonation plug on EMU by boasting that Europe's politicians had created an EU debt union on the sly. "It is expressly forbidden in the treaties. De facto, we have changed the treaty," he told the Financial Times. How will that go down at Germany's constitutional court, already facing a growing in-tray of claims that these bail-outs breach the Maastricht treaty?
For Spain it has been a horrible week. The central bank seized CajaSur and imposed draconian write-down rules on banks to 'restore confidence'. The Spanish Socialist and Workers Party (PSOE) of Jose Luis Zapatero then rammed a 5% cut in public wages through the Cortes by a single vote, shattering consensus. The government cannot hope to pass a budget. Its own trade union base is planning a general strike.
The subtext of Fitch's 32-page report shows Mr Zapatero's self-immolation to be futile in any case. The agency has not downgraded Spain for lack of austerity. Its implicit conclusion is that the policy of 1930s wage cuts— or "internal devaluations"— being imposed on southern Europe's humiliated states as a quid pro quo for the EU shield is itself part of the problem. Ultra-austerity will bleed the economy, shrivel tax revenues and fail to close the deficits anyway. "Fitch believes the risk is that economic growth will fall short of the government's projections," it said.
El Pais spoke of a "perverse spiral" in its editorial.
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Spain's unemployment was already 20.5% even before this latest dose of shock therapy. There are 4.6m people without work. Dole payments alone account for half the budget deficit. By comparison, the Anuario Estadístico shows that Spain's unemployment never rose above 9.5% during the Great Depression. The economy shrank by 3% from peak to trough. The Zapatero slump is worse than anything inflicted by Gil Robles during the Bienio Negro.
It is no mystery why Spain is trapped in depression. The country joined the euro without grasping its Faustian implications, as did others. Germany was equally naive in thinking it could have a currency union entirely on its own terms.
EMU caused Spanish interest rates to halve overnight, with dire results as the Bank of Spain's governor confessed in April 2007. "The single monetary policy has meant that excessively loose conditions for our economy have been almost continuous," he said. Real rates were -2% as the bubble reached its crescendo. Nearly 800,000 homes were built in 2007, more than in Britain, Germany, and Italy combined. There is now an overhang of 1.6m unsold properties, six times the level per capita as in the US. Total public/private debt has reached 270% of GDP.
The boom was a debt illusion, just as it was in Britain but with the added twists of lower wealth to offset household debt and a global investment position that is underwater by 70% of GDP. Britain still has the instruments to extricate itself. The Bank of England has engineered a devaluation of 20%, restoring competitiveness at a stroke. Spain can try to claw back an even greater loss by cutting wages, but that risks a slow death by debt-deflation as compound interest tightens its vice.
This can end only in two ways. Either Germany tolerates massive monetary reflation by the ECB or Spain will be forced out of EMU, setting off a catastrophic chain-reaction through north Europe's banking system.
Your choice, Berlin.
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Spain Orders Banks To Come Clean On Debts To Restore Shattered Faith
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By Ambrose Evans-Pritchard | 27 May 2010
The new rules target the savings banks or cajas that account for the lion's share of the €445bn (£377bn) of property debt accumulated during the credit boom, when real interest rates were negative. The authorities acted after severe strains in the inter-bank market had begun to raise questions about the ability of Spanish lenders to access routine funds from global peers. Deutsche Bank said Spanish lenders need to refinance €125bn by late 2011. "Liquidity is our main area of concern. Savings banks are in a very weak and risky position," it said.
Even the strongest banks— Santander and BBVA— are paying a stiff premium over Libor. The Wall Street Journal reports that BBVA has been unable to roll over €1bn in commercial paper. This has raised fears of a chain reaction through Europe's banks due to the nexus of loans. Data from the Bank for International Settlements show that European banks— led by German lenders, in some trouble themselves— have $851bn (£584bn) in exposure to Spain, as well as $240bn to Portugal and $189bn to Greece.
No Spanish bank has raised money on the capital markets for a month. They are relying on the European Central Bank's lifeline. ECB funding has reached €89bn, the highest level since the Lehman Brothers crisis.
The new rules will force lenders to write down bad debts within a year instead of stretching out the pain for up to six years. They must set aside reserves on €60bn of foreclosed property still sitting on their books at face value, using a rising scale of up to 30%. Santander and BBVA have already done this.
"Spanish accounting was completely out of line with the rest of Europe," said Hans Redeker, currency chief at BNP Paribas. "It had reached a point where investors no longer believed in Spanish balance sheets because equity ratios are distorted by overvalued holdings of real estate. This move was absolutely the right thing to do. You can't camouflage bad debts any longer. Those days are over," he said.
The Bank of Spain risks opening a Pandora's Box since nobody knows how many cajas are insolvent once loans are marked-to-market. Last weekend it seized CajaSur, a 150 year-old lender in Cordoba controlled by the Catholic Church. The lender lost €596m last year, much of it on holiday homes on the Costa del Sol.
The regulator said the measures would cut bank earnings by 10% on average but warned of a "very heterogeneous" effect, a polite way of saying that it will purge cajas that ran amok. The crackdown will bring matters to a head rapidly, forcing cajas to disgorge property holdings onto the market. This is a gamble, risking a house-price crash that could tip Spain deeper into debt deflation.
Caixa Catalunya said the stock of unsold homes reached 926,000 last year. Madrid consultants RR de Acuña are gloomier, saying buildings in the pipeline will push the overhang to 1.6m and will take six years to clear. New home starts have fallen 90% from their peak in 2007.
Santiago Lopez from Credit Suisse said the new rules may prove "the last straw" for weak cajas but praised the central bank for "finally deciding to get tough". He said the non-performing loan rate in Spain is 5.33% but past interventions by the central bank revealed "dramatic" rises in NPL ratios after a fresh audit. Once the full truth comes out on CajaSur we will know how bad the picture is for others.
Mr Lopez said Spain's Achilles Heel is private debt of 211% of GDP. This is much like Britain (213%), but takes places in the very different context of deflation. Spain cannot easly grow its way out of the crisis because it is structurally overvalued within the EMU.
Regulators are hoping to break the political resistance to shotgun mergers or debt restructuring. Four other cajas have been ordered to merge already. The policy of throwing banks together entails its own dangers, risking a repeat of the Lloyds TSB deal with HBOS or a string of 1990s mergers in Japan where bad banks polluted good banks. There is no magic wand to conjure away a stock of bad debt.
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Europe Facing Strikes Over Austerity Packages
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By Ambrose Evans-Pritchard | 27 May 2010
Its glaring lack of political solidarity is the latest sign of rising resistance to deflation policies across the eurozone. Prime minister Jose Luis Zapatero had to rely on the abstention of Catalan nationalists to push through public sector wage cuts of 5% this year and a freeze in 2011. The 1930s-style pay squeeze was effectively imposed upon Spain by Brussels as a quid pro quo for the EU's €750bn "shield" for eurozone debtors. It is a bitter climb-down for a workers party that vowed to resist salary cuts. Public sector unions have called a strike on June 8 to protest an act of "ultimate aggression" against the people.
The conservatives voted against the measures, prompting a fiery rebuke from finance minister Elena Salgado. "Unpatriotic, irresponsible, and hardly very European: one day they will pay for this," she said. The measures include cancellation of the €2,500 "baby cheque" and lower pension benefits. Mr Zapatero hopes to cut the deficit by an extra 1.6% over GDP over two years, though unemployment is already 20%. The deficit will fall from 11.2% in 2009 to 6% this year.
Raj Badiani from IHS Global Insight said cuts may not be enough. The government is relying on growth projections that are "far too optimistic" to do the heavy lifting of the deficit reduction. In Italy, the main CGIL trade union is launching two sets of strike in June to protest "unjust and unsustainable" cuts announced on Tuesday night, claiming that the axe falls squarely on ordinary workers. "Those who earn over €500,000 won't have to put up a single cent," it said.
Premier Silvio Berlusconi said the sovereign bond scare sweeping the eurozone had forced Italy to build up a security buffer. "This crisis has been provoked by speculation and is like no other. These sacrifices are necessary to save the euro," he said. The €24bn austerity package (1.6% of GDP) over two years aims to cut the bloated bureaucracy, chiefly by reducing grants to regional governments. "Italy's spending is out of control: this irresponsible system worked as long as we could devalue the currency," said Mr Berlusconi.
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US Money Supply Plunges At 1930s Pace As Obama Eyes Fresh Stimulus
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By Ambrose Evans-Pritchard | 26 May 2010
The M3 figures— which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance— began shrinking last summer. The pace has since quickened. The stock of money in the US fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6%. The assets of insitutional money market funds fell at a 37% rate, the sharpest drop ever.
"It's frightening," said Professor Tim Congdon from International Monetary Research. "The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly," he said.
The US authorities have an entirely different explanation for the failure of stimulus measures to gain full traction. They are opting instead for yet further doses of Keynesian spending, despite warnings from the IMF that the gross public debt of the US will reach 97% of GDP next year and 110% by 2015. Larry Summers, President Barack Obama's top economic adviser, has asked Congress to "grit its teeth" and approve a fresh fiscal boost of $200bn to keep growth on track. "We are nearly 8m jobs short of normal employment. For millions of Americans the economic emergency grinds on," he said.
David Rosenberg from Gluskin Sheff said the White House appears to have reversed course just weeks after Mr Obama vowed to "rein in" a budget deficit of $1.5 trillion (9.4% of GDP) this year and set up a commission to target cuts. "You truly cannot make this stuff up. The US governnment is freaked out about the prospect of a double-dip," he said.
The White House request is a tacit admission that the economy is already losing thrust and may stall later this year as stimulus from the original $800bn package starts to fade. Recent data have been mixed. Durable goods orders jumped 2.9% in April but house prices have been falling for several months and mortgage applications have dropped to a 13-year low. The ECRI leading index of US economic activity has been sliding continuously since its peak in October, suffering the steepest one-week drop ever recorded in mid-May.
Mr Summers acknowledged in a speech this week that the eurozone crisis had shone a spotlight on the dangers of spiralling public debt. He said deficit spending delays the day of reckoning and leaves the US at the mercy of foreign creditors. Ultimately, "failure begets failure" in fiscal policy as the logic of compound interest does its worst.
However, Mr Summers said it would be "pennywise and pound foolish" to skimp just as the kindling wood of recovery starts to catch fire. He said fiscal policy comes into its own at at time when the economy "faces a liquidity trap" and the Fed is constrained by zero interest rates. Mr Congdon said the Obama policy risks repeating the strategic errors of Japan, which pushed debt to dangerously high levels with one fiscal boost after another during its Lost Decade, instead of resorting to full-blown "Friedmanite" monetary stimulus.
"Fiscal policy does not work. The US has just tried the biggest fiscal experiment in history and it has failed. What matters is the quantity of money and in extremis that can be increased easily by quantititave easing. If the Fed doesn't act, a double-dip recession is a virtual certainty," he said.
Mr Congdon said the dominant voices in US policy-making— Nobel laureates Paul Krugman and Joe Stiglitz, as well as Mr Summers and Fed chair Ben Bernanke— are all Keynesians of different stripes who "despise traditional monetary theory and have a religious aversion to any mention of the quantity of money". The great opus by Milton Friedman and Anna Schwartz— The Monetary History of the United States— has been left to gather dust.
Mr Bernanke no longer pays attention to the M3 data. The bank stopped publishing the data five years ago, deeming it too erratic to be of much use. This may have been a serious error since double-digit growth of M3 during the US housing bubble gave clear warnings that the boom was out of control. The sudden slowdown in M3 in early to mid-2008— just as the Fed talked of raising rates— gave a second warning that the economy was about to go into a nosedive.
Mr Bernanke built his academic reputation on the study of the credit mechanism. This model offers a radically different theory for how the financial system works. While so-called "creditism" has become the new orthodoxy in US central banking, it has not yet been tested over time and may yet prove to be a misadventure. Paul Ashworth at Capital Economics said the decline in M3 is worrying and points to a growing risk of deflation. "Core inflation is already the lowest since 1966, so we don't have much margin for error here. Deflation becomes a threat if it goes on long enough to become entrenched," he said.
However, Mr Ashworth warned against a mechanical interpretation of money supply figures. "You could argue that M3 has been going down because people have been taking their money out of accounts to buy stocks, property and other assets," he said. Events may soon tell us whether this is benign or malign. It is certainly remarkable.
** While the Fed does not publish M3, it still publishes the underlying components. The indicator is reconstructed accurately for clients by Dr John Williams. See it here.
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Double-Dip Fears Over Worldwide Credit Stress
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By Ambrose Evans-Pritchard | 25 May 2010
Anti-government protesters take cover behind a burned-out truck during clashes in Bangkok, a reminder of Asian risk factors the markets have been overlooking Photo: EPA
Flight to safety drove yields on 10-year German Bunds to 2.56%, below the levels touched in the depths of the Great Depression. The spreads over peripheral European debt rose sharply again, jumping to 137 basis points for Italy, 157 for Spain and 220 for Ireland. The strains in Europe's sovereign debt markets are nearing levels that forced EU leaders to launch their "shock and awe" rescue package. "If a $1 trillion (£700bn) bail-out did not finally turn sentiment, I struggle to see what can," said Tim Ash, an economist at RBS.
Dollar Libor rates gauging stress within the interbank lending market have jumped to a 10-month high of 0.5363%, with credit contagion spreading to every area. The iTraxx Senior financials index— banks' "fear gauge"— rose 20 basis points on Tuesday to 184. "It turns out we weren't seeing the light at the end of the tunnel after all, but a train with a big light on it coming towards us of double-dip," said Dr Suki Mann, at Societe Generale.
While the Libor rate is still far below peaks reached during the Lehman crisis, the pattern has ominous echoes of credit market strains before the two big "pulses" of the credit crisis in August 2007 and September 2008. In each case a breakdown of trust in the interbank market was a harbinger of violent moves in equities and the real economy weeks later. RBS's credit team said Libor strains were worse than they looked since most banks in Europe were paying much higher spreads, especially in Spain. The "implied" forward spreads were nearer 1.1%.
The damage has spilt over to corporate bonds, effectively shutting the market for new issues. May will be the worst single month for debt issues since December 1999, with seven deals being cancelled in recent days. Volume has collapsed to $47bn from $183bn in April, according to Bloomberg.
Mr Ash said North Korea's decision to cut all ties with the South and abrogate its non-aggression pact— coming days after Thailand sent tanks into Bangkok to crush the Red Shirts— has played into the chemistry of angst gripping markets, adding it was a reminder that Asia has "political/social stress points". This risk was overlooked during the honeymoon phase of emerging markets when investors were intoxicated by the China story.
Fears that America may slip back into a double-dip recession are returning. Larry Summers, the White House economic tsar, has called for a second stimulus package to keep the recovery on track, warning that the US economy is still in a "very deep valley". The S&P Case-Shiller index of home prices is declining again as incentives for homebuyers expire and the slow-burn effect of rising delinquencies exacts its toll. Prices fell 3.2% in the first quarter of this year. "There are signs of some renewed weakening in home prices", said David Blitzer from S&P.
The epicentre of the credit crisis is moving to Spain where the seizure by the central bank of CajaSur over the weekend has torn away the veil on credit damage from Spain's property crash. Bank stocks fell 6% in Madrid in early trading on Tuesday on fears that funding will dry up for the cajas— or the savings banks— setting off a broader credit crunch. The cajas hold the lion's share of loans to property companies and developers, estimated at €445bn (£380bn) or 45% of GDP by Goldman Sachs.
Spanish construction reached 17% of GDP at the height of the bubble as real interest rates of minus 2% set by the European Central Bank for German needs played havoc with the Spanish economy. This was almost double the level in the US during the sub-prime booms. The result is an overhang of unsold Spanish properties equal to four years' demand.
Markets have been rattled by reports in the German media that the Greek rescue deal contains two secret clauses. The package will be "immediately and irrevocably cancelled" if it is found to breach the EU Treaty's "no bail-out" clause, either in a ruling by the European court or the constitutional courts of any eurozone state. While such an event is unlikely, it is not impossible. There are two cases already pending at Germany's top court in Karlsruhe, perhaps Europe's most "eurosceptic" tribunal.
The second clause said that if any country finds it cannot raise funding for the rescue at interest rates below the 5% charge agreed for Greece, it may opt out of the bail-out. BNP Paribas said this would escalate quickly into a systemic crisis if Spain were in such a position, because the other countries cannot carry an ever-rising burden. The bank warned the euro project itself may start to disintegrate rapidly if these rescue provisions are ever seriously put to the test.
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Europe's Deflation Torture Is A Gift To The Far Left
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By Ambrose Evans-Pritchard | 23 May 2010
The tragedy of the interwar years in Germany was that the Social Democrats— then the world's foremost socialist party— became fatally tainted by acquiescing in Bruning's deflation torture from 1930 to 1932. They did so, of course, because they dared not confront the orthodoxies of the Gold Standard. By then the fixed-exchange mechanism had gone horribly wrong— in much the same way that EMU has gone horribly wrong— because the surplus countries were not recycling demand to maintain equilibrium. It had become a job-destruction machine. The result in Germany was the Reichstag election of July 1932 when the Communists and Nazis won over half the seats. [[And the 'center' chose Hitler as the lesser of two evils!: normxxx]]
As historian Simon Schama wrote over the weekend in the Financial Times— "The world teeters on the brink of a new age of rage: we face a tinderbox moment"— there is typically a lag-time between economic shocks and social fury. Luckily there is no Fascist threat this time. It is the (more benign) Marxist Left that stands to gain.
Perma-slump has already chipped at the left flank of the ruling Socialists in Portugal. The Communist Party (PCP) and the Maoists and Trotskyists of the Left Bloc together won 18% of the vote in September 2009, leaving premier Jose Socrates with the lonely task of enforcing yet more austerity by minority government. Communist leader Jerónimo de Sousa said last week that the country was being reduced to a "protectorate of Brussels", cowed into submission by financial blackmail. He invoked the civil war in 1383 when the country rallied heroically to expel the foreign opressor— with English help, the "ultimato inglês" as he calls it— from Portuguese soil.
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What this comes down to is "ownership" of austerity policies. It is hard enough for the elected parliament of an ancient and sovereign nation to impose cuts— as Britain discovered in September 1931 when Royal Navy ratings at Invergordon refused to set sail after the Admirality docked pay by a shilling— but what is the charisma and ordaining legitimacy of an EU council of ministers meeting behind closed doors in Brussels?
Portugual is not unique. I spent Saturday delving into the subcultures of Italy's Rifondazione Comunista, Spain's Izquierda Unida, Olivier Besancenot's Parti Anti-Capitaliste in France, and Germany's Linke (Left). While it is too early to talk of a pan-European revolt against EMU-deflation, the Left is starting to offer the only coherent critique of what has gone wrong with monetary union and why there can be no durable solution until the EU creates full fiscal union (which creates its own problems of permanent subsidies, as from Ostrogoth Padania to Berber Sicily under the lira) or until this latter day Gold Standard is broken into viable halves.
It was refreshing to read "The Euro Burns" by Michael Schlecht, Die Linke's economic guru, arguing that the primary cause of Euroland's crisis is "German wage-dumping". He shows from Eurostat data that German labour costs rose 7% between 2000 and 2008, compared to 34% in Ireland, 30% in Spain, Portugal, and Italy, 28% in Greece and Holland, and 20% in France. Again, my loose translation.
Germany ran an accumulated trade surplus of €1,261bn over the period, while Spain ran a deficit of €598bn, and Portugal minus €273bn. This shell game was kept afloat by recycling German capital to Club Med debt markets beyond sustainable levels until it all blew up over Greece. The Club Med victims are now trapped.
"Had Britain not been able to create breathing space by devaluing the pound, the situation for England would perhaps be even graver than for Greece. No wonder nobody in Britain is even thinking about joining the euro," he said. Quite so.
Berlin prides itself on German wage discipline, insisting that others should do the same. Chancellor Merkel implicitly blames the euro debacle on (allegedly) feckless Greeks and Latins, but the logic of EMU is that cultural Germans must meet cultural Latins half way. Her quid pro quo for the €750bn EMU "shield" is ultra-austerity in the South.
This belt-tightening is intellectually absurd, comes too late to rebalance EMU, and has now run amok. Spain is cutting public sector wages by up to 7% this year. Greece has swallowed a de facto cut of 16%. Italy is preparing a wage freeze as part of a €25bn austerity plan over two years. France has joined with plans for a three-year freeze and a hair-shirt clause in the constitution. Pre-EMU Romania is cutting wages by 25%, so take that you wimps. Romania's police union has vowed to bring down the government, threatening to "do what we did in 1989, when we overthrew the dictatorship".
The IMF's Dominique Strauss-Kahn is having second thoughts about a synchronized fiscal squeeze across half Europe. "Growth in Europe is by far too low. Germany and the other countries must urgently do more to accelerate growth. The whole world is watching this and is losing confidence in Europe," he said.
The Left always warned that EMU was a "Bankers' Ramp", an instrument of creditor control that would lock in 'reactionary' policies. Little did they know how extreme this would prove to be. Greece is having to go through the harshest fiscal cuts ever attempted in a developed economy under its EU-IMF plan, without offsetting exchange and monetary stimulus. The agony is pointless. The IMF admits that Greece's public debt will rise from 120% to 150% of GDP by 2014. The country is already past the point of no return.
Such a policy is not in the interests of Greek society. Greece should leave the euro and carry out a controlled default, sharing the pain with foolhardy creditors. The EU is preventing this cure: either to protect bond-holders— ie, French and German banks— giving them time to shuffle off their bad debts onto EU taxpayers; or because Brussels refuses as a matter of ideological principle to countenance any step back, ever, in the sacrosanct Project.
It is undeniable that Europe needs to master its debts— but not by tipping a clutch of countries into debt-deflation, a policy that will cause each to feed off the crisis of its neighbours in a self-feeding downward spiral. The only way out is for the European Central Bank to lift Club Med off the deflation reefs by monetary stimulus, and allow these economies to work off their debt in an orderly fashion without shrinking nominal GDP. That means quantitative easing a l'outrance ["to the utmost"]— not "sterilising" bond purchases as it has done so far— and that in turn means that Germany must accept 5% inflation.
Will Germans tolerate such an outcome? The civil peace of Europe demands that they do, but I am not hopeful. The Bundestag vote to authorise Germany's €147bn share of the EMU "shield" has already caused apoplexy. "One of the gravest errors of decision in the history of the Federal Republic of Germany," said Hans Werner Sinn, head of the IFO Institute.
Bavarian politician Peter Gauweiler is launching a legal challenge at Germany's constitutional court to block the rescue, arguing that the "contractual foundations of monetary policy" as fixed by the Maastricht Treaty have been breached. The legal cases are piling up. It is remarkable that so much time has been spent by City [the UK's equivalent of Wall street] analysts combing through Greek data to gauge the risk of default, yet so little time has been spent thinking about these cases at Karlsruhe. How many have read the court's rulings on Maastricht and Lisbon? Yet the "tail-risk" is nuclear.
The North-South divide within EMU has been allowed to go so far that any solution must now be offensive to either side, and therefore will be resisted. The euro is becoming an engine of intra-European tribal hatred. Brilliant work, Monsieur Delors.
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Perfect Storm' As Market Tremors Hit China, Europe And The US
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By Ambrose Evans-Pritchard, International Business Editor | 21 May 2010
"It is the perfect storm," said Andrew Roberts, credit strategist at RBS. "People have been too complacent about risky assets. This is a global deflation scare and people need to get ready for falls in US and European bond yields to 2%."
The global stock market sell-off continued for a third day on Friday. London's FTSE 100 dropped 2% to trade below 5,000 for the first time since last October. Germany lost 2.4%, France 2.2%, Japan 2.5%, while Wall Street opened lower.
Investors shrugged off German approval of a $1 trillion (£700m) eurozone rescue package, doubtful that it can resolve the debt crisis. World equities are now heading for the biggest monthly fall since October 2008. Wall Street shares plunged 3% on Thursday after new jobless claims in the US rose to 471,000 last week, the biggest jump in three months. The S&P 500 index of shares fell to 1080, triggering automatic stop-loss sales as it crashed through support on its 200-day moving average.
The US Conference Board leading indicator turned negative in April, the first drop since the depths of the Great Recession. This follows data showing an 11% slide in building permits, pointing to a double-dip slump in the US housing market later this year. Lumber prices have fallen 26% from their peak in April.
David Rosenberg from Gluskin Sheff said a fresh "train wreck" may be coming in the US mortgage market as rates on a wave of "option ARM" contracts reset upwards in September. This may compound a deflationary process already eating at the US economy as Washington's fiscal stimulus wears off and the effects of a stronger dollar feed through. Core inflation has dropped to the lowest since 1964.
Meanwhile, monetary tightening in China has begun to set off tremors. Shanghai's bourse has tumbled 20% since mid-April (or 58% from its 2007 peak), dragging down oil and base metals. This may prove more than a refreshing pause. Ben Simpfendorfer, RBS's China economist, said credit tightening since April was needed to cool the property bubble, but "regulatory tightening is not a precise science and there is a risk the measures cause an abrupt correction in property prices and construction. It might be that China provides the next surprise". Goldman Sachs said that there were signs "beneath the radar" that China may be slowing, citing reports that property sales had dropped 80% in Beijing in the first half of May compared to a month earlier.
Above all, nothing has been resolved in Europe. The short-ban on bond trades this week by Germany's regulator BaFin comes as the Libor-OIS spread used to gauge strains in the interbank market flashes warning signs, rising to a nine-month high of 25 basis points. The iTraxx Crossover measuring corporate bond risk jumped 45 points to 620 yesterday. "The way the market is behaving right now suggests that investors are getting set for something nasty to happen," said Suki Mann from Societe Generale.
Regulatory clamp-downs are often symptomatic of stress. Wall Street crashed 28% over eight days after the US Securities and Exchange Commission imposed a short ban in September 2008. While BaFin's move has been dismissed as political posturing, the story may be more complicated. An internal BaFin note in February said German banks held €522bn of exposure to state bonds in Portugal, Italy, Ireland, Greece and Spain. It warned of "violent market disruptions" if contagion spread beyond Greece, triggering a "downward spiral in these countries, as in the case of Argentina".
Investors are baffled by the cacophony of voices in Europe. A day after German Chancellor Angela Merkel said the euro was in "existential danger", French finance minister Christine Lagarde replied that "the euro is absolutely not in danger". Details of last week's EU summit confirm early reports that Ms Merkel was ambushed by a French-led bloc, agreeing to demands for a €750bn rescue package for Club Med under duress.
Karl Otto Pöhl, ex-head of the Bundesbank, told Der Spiegel that the bail-out offers no help to Greece. The country can never repay its debts and needs "partial" forgiveness. "This was about was about protecting German banks, but especially the French banks, from debt write-offs," he said.
While Ms Merkel is likely to win backing for the rescue in the Bundestag on Friday, this does not settle the deeper issue of whether the German public will accept an EU debt union. Articles in the German media have questioned whether the country should remain part of EMU. "Should we bring back the Deutschemark"? screamed a front-page story in Bild Zeitung. Fresh cases challenging Germany's EMU membership are certain.
France may have won a Pyhrric victory, securing a short-term triumph at the cost of alienating the German people and setting off a political process that may cause Germany to turn its back on EMU.
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Germany's 'Desperate' Short Ban Triggers Capital Flight To Switzerland
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By Ambrose Evans-Pritchard, International Business Editor | 19 May 2010
An internal memo at the time showed that BaFin feared write-offs might top €800bn (£688bn), twice the reserves of Germany's financial institutions. Nobody paid much attention. But the regulator's shock move on Tuesday night to stop short trading on banks, insurers, eurozone bonds— as well as a ban on credit default swaps (CDS) on sovereign debt— has left the markets wondering whether the slow fuse on Germany's banking system has finally detonated.
BaFin spoke of "extraordinary volatility" and said CDS moves were jeopardising "the stability of the financial system as a whole". It is unsettling that the BaFin should opt for such drastic measures a week after EU leaders thought they had overawed markets with a €750bn rescue package and direct purchases of Greek, Portuguese and Spanish debt by the European Central Bank. BaFin's heavy-handed move seems to proclaim that the rescue has failed.
"The market is left asking what skeletons are lurking in the cupboard," said Marc Ostwald from Monument Securities. The short ban follows a report by RBC Capital Markets that circulated widely in the City accusing German banks of failing to come clean on 75% of their €45bn exposure to Greek debt. German lenders have the lowest risk-weighted capital ratios in the world after Japan. They were slow to rebuild safety cushions after the sub-prime crisis, and now face a second set of losses on Club Med holdings. Reporting rules have let Landesbanken delay write-downs, turning them into Europe's "zombie" banks.
Even so, nothing adds up in this BaFin episode. Germany acted alone, prompting a tart rebuke from French finance minister Christine Lagarde. "It seems to me that one should at least seek the advice of the other member states concerned by this measure," she said. Brussels was not notified. The deep rift between Berlin and Paris has been exposed again, leaving it painfully clear that Europe's monetary union still lacks the fiscal and governing machinery of a viable currency union.
Far from stabilising markets, BaFin's move set off a nasty sell-off in credit markets. Markit's iTraxx Crossover index— measuring risk in mid-level corporate bonds— jumped 57 basis points to 586. Markit said BaFin had caused liquidity to dry up in "febrile conditions". The Libor-OIS spread— closely watched for signs of strain in interbank lending— widened further.
If the purpose of BaFin's action was to drive wolfpack "speculators" off Greece's back, it failed. Yields on 10-year Greek bonds rose 37 basis points to 7.918%. What it showed is that CDS contracts barely matter. The issue is whether "real money" investors such as the Chinese central bank are willing to buy Greek and Portuguese debt.
The short ban set off instant capital flight to Switzerland. BNP Paribas said €9.5bn flowed into Swiss franc deposits in a matter of hours on Wednesday morning. The Swiss central bank intervened to hold down the franc. This caused the euro to shoot back up against the US dollar after an early plunge. The euro had already bounced off "make-or-break" technical support at $1.2135, the 50% "retracement" of its entire rise since 2000, but any rally is likely to be short-lived.
"As a German citizen, I wish to apologise for the stupidity of my government," said Hans Redeker, currency chief at BNP Paribas. He said the CDS ban deprives reserve managers of a crucial hedging tool for non-securitised loans and will scare away global investors needed to soak up Club Med bonds. "The European market is likely to become utterly dysfunctional. Just as the market showed signs of stabilisation with real money starting to buy euros, the Germans have destroyed this glimmer of hope," said Mr Redeker. "The BaFin ban is a desperate political move by a government battling for survival. Angela Merkel needs the support of the Left so she has given in to a witch-hunt against banks and speculators."
Six members of the FDP Free Democrats in Germany's ruling alliance are to vote against the EU's rescue fund. Chancellor Merkel must reach out to Social Democrats and Greens to secure a safe majority. Mrs Merkel faced heckling as she tried to rally support for the EU rescue package in the Bundestag. "The current crisis facing the euro is the biggest test Europe has faced since the Treaty of Rome in 1957. This test is existential. The euro is in danger, and if we do not avert this danger, the consequences will be incalculable," she said.
Tim Congdon from International Monetary Research said deposit data from the ECB shows that there was a "major run" on Club Med banks in the second week of May. Some €56bn of interbank lending facilities were withdrawn, probably as citizens in the South switched funds to banks in the eurozone core. Bank reliance on the ECB lending window jumped by €103bn— or 22%— in a week.
"It was extreme and very sudden, probably on Friday afternoon. The eurozone was undoubtedly in peril," he said. The question raised by BaFin is whether underlying damage to the eurozone banking system runs even deeper than feared.
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Funds Embrace America In Flight From Risk
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By Ambrose Evans-Pritchard, International Business Editor | 18 May 2010
The May survey of investors by Bank of America Merrill Lynch showed revulsion towards the euro and European shares as funds battened down the hatches for a global "growth shock", switching their affections to "safe-haven" America in record numbers. "Investors have capitulated on Europe, beaten down by sovereign debt concerns and faltering growth expectations," said Gary Baker, the bank's chief European equity strategist.
Mr Baker said the "comfortable status quo view" that China's perma-boom and global recovery would last long enough to allow states to deal with their fiscal deficits had been shaken badly by the recent events. "Goldilocks has been mugged by the bears," said Mr Baker. The survey's "risk indicator" plummeted from 46 to 38, a sharper drop than during the worst months of the banking crisis.
Funds have woken up to the risk that Chinese credit tightening is a global game-changer. The Shanghai bourse is already in a bear market with a fall of 22% since November. The index is down 58% from its peak in 2007. At the same time eurozone countries are having to implement austerity packages to appease the bond markets, knocking away the growth props that underpin rosy profits forecasts.
A net 74% of fund managers favour the US over Europe, the widest margin since 2003. Preference for the dollar over the euro is at the highest level ever recorded. A net 66% said the dollar is the major currency most likely to appreciate over the next year. Some 90% think the European Central Bank will delay rate rises until 2011, up from 62% a month ago.
These survey results are not a tool for prediction. They are often a contrarian sign, indicating when a strategy has become too "crowded" and poised to swing in the opposite direction. Mr Baker said flight from European equities has become "stretched" and is "close to contrarian trigger levels".
Risk aversion has caused funds to raise their cash levels from 3.5% to 4.3%. This is still shy of a contrarian "buy signal" at 4.5%, suggesting that investors may want to keep their powder dry for a little longer. Merrill said bank shares were pervasively loathed again, making them a tempting buy.
The survey was carried out before the EU's $1 trillion plan to stabilise Southern Europe and before the ECB's purchase of bonds. Spreads on Greek, Portuguese, and Spanish debt have come down sharply, but the Libor-OIS spreads used to gauge stress in interbank lending shows that the market remains under strain. There was good news from Greece, however, which hopes to return to the capital market soon after cutting its budget deficit by 42% in the first four months of the year. Greece received a payment of €14.5bn in EU aid, the first tranche of its €110bn rescue package.
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Banks Dump Greek Debt On The ECB As Eurozone Flashes Credit Warnings
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By Ambrose Evans-Pritchard, International Business Editor | 17 May 2010
The Bank of New York Mellon said its custodial data showed a "sharp acceleration" of net sales of debt from the two countries after the ECB began purchasing €16.5bn of bonds from southern Europe and Ireland in bid to halt market panic. "It rather suggests that investors leapt at the opportunity to clear their balance sheets of intolerable risk," said Neil Mellor, the bank's currency strategist. "This leaves the ECB itself in an unpleasant situation since it now faces a deterioration in its own balance sheet."
While ECB action has greatly reduced bond spreads on peripheral eurozone debt, it has not yet stabilized the broader markets. The euro fell to a four-year low of $1.2260 against the dollar in early trading. Jean-Claude Juncker, the head of the Eurogroup, said on Monday that this risks becoming disorderly. "I'm not worried as far as the current exchange rate is concerned: I'm worried as far as the rapidity of the fall is concerned."
Crucially, there are still serious strains in the interbank lending market. Hans Redeker, currency chief at BNP Paribas, said the LIBOR-OIS spread in Europe used to gauge credit stress is flashing danger signals, hovering near levels seen during the Lehman crisis. The ECB's strategy of draining liquidity to offset the stimulus from the bond purchases risks making matters worse. "They are using one-week deposits for sterilisation and the effects of this to make short-term funding more expensive. This will force banks to sell assets to shrink their balance sheet and risks causing a credit crunch," he said.
Mr Redeker said the ECB is pursuing a contractionary policy to assuage concerns in Germany that Club Med bond purchases will stoke inflation. "They have read the German press and it made their hair stand up on their necks. The reality is that a deflationary cycle is developing in Euroland and the ECB will eventually have to start quantitative easing," he said.
Dominic Wison, market chief at Goldman Sachs, said talk of an EMU break-up were overblown but echoed concerned about strains in the short-term money markets. "The LIBOR-OIS spreads widened consistently through the week. Ongoing pressures on funding have not yet been quieted. As we saw in 2008 and 2009, those stresses— if they do not subside— are generally toxic for markets," he wrote in a client note.
A report by RCB Capital Markets said German banks have yet to come clean on 75% of their combined exposure to €45bn of Greek debt. The state-owned Hypo Re has revealed holdings of €7.8bn, equal to 243% of its tangible equity. Commerzbanks's subsidiary Eurohypo holds €3bn, or 77%, of its tangible equity.
RBS said that some German banks may face risks if there is a voluntary debt restructuring by Greece, since this would not trigger debt insurance contracts on credit default swaps. This would leave them facing much larger debt write-downs than they bargained for. Analysts say austerity measures across southern Europe are causing the euro to weaken further because they will dampen growth and may lead to protracted slumps, forcing the ECB to delay rate rises.
Italy is next in line for a fiscal squeeze, preparing €25bn of belt-tightening over the next two years. Leaks in the Italian media say Rome plans to freeze public sector wages, limit recruitment, and delay retirement. The goal is to build a "primary" budget surplus (before interest costs) of 1% of GDP in 2011 and 2.5% in 2012 in order to demonstrate discipline to the bond markets.
Finance minister Giulio Tremonti, who has been praised for his iron control of spending, aims to establish an ample margin of safety to secure Italy's place in monetary union. Italy's impressive efforts— following austerity packages in Ireland, Greece, Portugal, and Spain— show how much Britain has to do to avoid being left behind by other countries in what amounts to a 'beauty contest' over deficits and sovereign debt in global markets.
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Forget The 'Wolf Pack'— The Ongoing Euro Crisis Was Caused By EMU
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By Ambrose Evans-Pritchard | 16 May 2010
Mr Trichet was ash-white at the Brussels summit a week ago. He distributed charts of credit stress to every eurozone leader. By the time he had finished his hair-raising discourse, everybody round the table finally understood what they faced.
"The markets had ceased to function," he told Der Spiegel. "There is still a risk of contagion. It can happen extremely fast, sometimes within hours". The spreads on Greek, Iberian, and Irish bonds have, of course, dropped since the ECB stepped in with direct purchases. But the euro rally fizzled fast, to be followed by a fresh plunge to a 18-month low of $1.24 against the dollar. European bank stocks have buckled again. Spain's IBEX index fell 6.6% in capitulation fever on Friday.
Geneva professor Charles Wyplosz said EU leaders made the error of overselling their "shock and awe" package before establishing any political mechanism to mobilise such sums. "The fund is an empty shell," he wrote at Vox EU. "Worse still, crucial principles have been sacrificed for the sake of unconvincing announcements."
Brussels was unwise to talk of smashing the "wolf pack" speculators and defeating the "worldwide organised attack" on the eurozone. As Napoleon said, if you set out to take Vienna, take Vienna— don't just talk about it. Besides, the language of the EU priesthood— ex-ECB board member Tomasso Padoa-Schioppa's talks of the "advancing battalions" of the "anti-euro army"— frightens the Chinese and Mid-East investors needed to soak up EU debt. These metaphors are a mental flight from the issue at hand, which is that vast imbalances— masked by EMU, indeed made possible only by EMU— have been decorked by the Greek crisis and now pose a danger to the entire world.
One can only guess what Mr Trichet meant when he said we are living through "the most difficult situation since the Second World War, and perhaps the First". Is this worse than Credit Anstalt in the summer of 1931, the event that brought down central Europe's banking system and tipped Europe [[and the world: normxxx]] into depression? Or was Mr Trichet alluding to something else after witnessing the Brussels tantrum by President Nicolas Sarkozy?
According to El Pais, Mr Sarkozy threatened to pull France out of the euro and break the Franco-German axis at the heart of the EU project unless Germany capitulated. To utter such threats is to bring them about. You cannot treat Germany in that fashion.
Chancellor Angela Merkel has put the best face on a deal that has so damaged her leadership. "If the euro fails, then Europe fails and the idea of European unity fails," she said. Too late, I think. The German nation is moving on. I was struck by a piece in the Frankfurter Allgemeine proposing a new "hard currency" made up of Germany, Austria, Benelux, Finland, the Czech Republic, and Poland, but without France. The piece entitled, The Alternative, says deflation policies may push Greece to the brink of "civil war" and concludes that Europe would better off if it abandoned the attempt to hold together two incompatible halves. "It can be done," the piece says.
What makes this crisis so dangerous is not just that Europe's banks are still reeling, with wafer-thin capital ratios. The new twist is that markets are no longer sure whether sovereign states are strong enough to shoulder rescue costs. The IMF warned in last week's Fiscal Monitor that the tail risk of a "widespread loss of confidence in fiscal solvency" could no longer be ignored. By 2015 public debt will be 250% in Japan, 125% in Italy, 110% in the US, 95% in France, and 91% in the UK.
There is a way out of this crisis, but it is not the policy of wage deflation imposed on Ireland, Greece, Portugal, and Spain, with Italy now also mulling an austerity package. This can only lead to a [mutual] debt-deflation spiral. [[Á la the 1930's.: normxxx]] The IMF admits that Greece's public debt will rise to 150% of GDP even after its squeeze, and that Spain's budget deficit will still be 7.7% of GDP in 2015.
The only viable policies— short of breaking up EMU or imposing capital controls— is to offset fiscal cuts with monetary stimulus for as long it takes. Will it happen, given the conflicting ideologies of Germany and Club Med? Probably not. The ECB denies that it is engaged in Fed-style quantitative easing, vowing to sterilise its bond purchases "euro for euro". If they mean it, they must doom southern Europe to depression. But no democracy will immolate itself on the altar of 'monetary union' for long.
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Normxxx
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