After looking at the rather extraordinary announcements from euro zone ministers and the Managing Director of the International Monetary Fund yesterday it was quite clear that Monday 10th May was going to be an important day in the history of the Euro project. Indeed we saw quite extraordinary market moves but as I wrote in my analysis on it even at the introduction of the plan it was dawning on me that the euro zone was in danger of repeating past mistakes and was again only really dealing with liquidity problems. In addition I fear that any short-term victory over what they call “speculators” will be bought at the price of the (remaining) credibility of the European Central Bank. Those who saw BBC’s Newsnight programme last night will have seen Christine Lagarde the French Finance Minister taking the opportunity to grandstand and virtually claim victory already which I think will disturb anyone who realises that long-term problems are the real issue and these cannot be fixed in a day.
This was rather extraordinary in the world’s and particularly Europe’s equity markets. There is a Dow Jones stoxx 600 index for Europe and it rose by 7.2%. The leaders in this regard were Europe’s banks where double digit gains in percentage terms were common, as an example Banco Santander jumped by 23%. When you consider that it is Spain biggest listed company (again as it lost this title in last weeks falls) and also the biggest bank by market capitalisation in Europe then I think you get an idea of the scale of the moves. You may also be inclined more towards my view that yet again we are seeing a bank bail out rather than one of countries! How exactly is a firm the size of Banco Santander able to rally 23% in a day otherwise?
European sovereign bond markets saw strong rallies too. However here there is a more cautionary note as there was a lot of talk that the ECB was pretty much the only buyer of these assets. Anyway the yield on Greek ten-year government bonds fell to 8.26%, Portugal’s equivalent fell to 4.88%, Ireland’s to 4.70% and Spain’s to 4%. Whilst these are indeed considerable improvements Greek bond yields remained at a level she cannot afford, if they were at these levels and she had to refinance in the markets then in effect she would be insolvent.
The exchange rate of the euro was the weakest picture. Having rallied from its lows of last week to just under US $1.29 as Elena Salgado made Europe’s statement we then saw a further rally to over US $1.30. However since then it has set back to US $ 1.273 and this is not a great return on a plan “to save the Euro”.
I thought that the save the Euro claims of the European Ministers were a little odd. For one thing which would provide some assistance in the crisis would be a fall in the Euro’s exchange rate as it would lead to a boost in economic growth which would be helpful. Of course it might lead to more economic divergence as I have discussed before but for the moment with fiscal austerity plans spreading Europe desperately needs all the economic growth it can get. Not for the first time European Ministers were grandstanding and waffling.
The European Central Bank
This institution was perhaps the most changed by yesterdays announcements and in some respects may have been in shock as its President had said that the Governing Council had not even discussed buying sovereign debt only 3 days before. We now know that some ECB members voted no and whilst it was a case of the likely suspects it is also significant that the main two are German. After all Germany will be the main paymaster of any plan. Indeed Axel Weber who is the head of the Bundesbank as well as an ECB Council Member has been quoted in the German press as saying.
“The purchase of government bonds poses significant stability risks and that’s why I’m critical toward this part of the ECB council’s decision, even in this extraordinary situation,” and “It’s now critical to keep these risks as minimal as possible.”
1. When you announce a policy change as significant as this I feel that you need a unanimous vote and the ECB did not achieve this and sooner or later trouble will come from this route.
2. The independence of the ECB has in my view been fatally compromised as it has been forced to dance to the tune of euro zone ministers. Mr.Trichet confirmed this by saying that the ECB remains “fiercely independent” as the fact that you have to discuss something like this means that you have lost it.
3. When the ECB was founded it was argued particularly by the Bundesbank in Germany that it would be irresponsible for central banks to finance deficits, arguing that this would kindle inflation and rely on government assistance if the purchases turned sour. So we have an abandonment of the idea that Bundesbank principles will run the ECB. This is important as at times markets have treated the Euro as almost a replacement for the old German deutschemark rather than a currency which is the average of its members.
4.Whilst the ECB looks as though it is reducing any monetary impact of its sovereign debt purchases by sterilisation it remains true that it is in effect reducing the credit rating of its own assets and itself. In some ways this is not so dissimilar to the sub-prime game played in the past is it? Repackage something up and give it an inaccurate credit rating and hope nobody notices….Also its moves are similar to a tax in that sterilisation involves taxing other (prudent) euro-area borrowers to support a government in fiscal distress presumably as a result of imprudence.
The more idea 3 gains ground the more I feel that we will see the Euro exchange rate fall. However there is a cautionary note in that most currencies at present have weaknesses and as they are measured against each other they all cannot fall! Even so the Euro may well fall further.
Economic Growth and Competitiveness
In the end these are two powerful engines which could solve or at least help to solve the sovereign debt programme. However we have heard very little on them apart from some vague promises on behalf of Spain and Portugal. I got the impression that these promises had been written on the back of a postage stamp because there was no detail at all from Elena Salgado. This must have been a little embarrassing as she is Spain’s Finance Minister! Indeed a questioner pointed out that Spain’s Prime Minister had only a month ago said that a new austerity plan for Spain would be a bad idea as it would reduce economic growth. However on an important issue we only got waffle I am afraid. The danger of a vicious circle of austerity plans leading to reduced economic growth was ignored and glossed over.
Rather curiously they forgot to mention Ireland at all, you see she has the highest fiscal deficit in the euro zone….
Apart from the admittedly rather vague talk about Spain and Portugal all we got here was even vaguer talk. If this remains so then I think minds will focus ever more on the fact that this is in effect a bail out of the imprudent by the prudent and that there is no real plan for change on a sufficient scale for the imprudent.
The International Monetary Fund
Am I alone in wondering about the consequences of its role in this operation? Again we see promises of huge sums from this organisation and yet as they are promises they do not show up anywhere. It would appear that the whole world is in danger of being sucked into an off-balance sheet nightmare. Also what happens if the IMF’s resources are called upon elsewhere?
This leads me to a further issue with the plan you see of the 750 billion Euros how much actually exists? The Special Purpose Vehicle does not and so nor does the IMF lending linked to it so this subtracts some 660 billion Euros. So we are left with the 60 billion Euro stabilisation fund and 30 billion of extra IMF lending. 90 billion does not sound quite so grand does it? We are left with the impression that the euro zone wanted to impress people with numbers which has the flaw that sooner or later they get unpicked.
What was presented in terms of “shock and awe” has clear flaws as I have highlighted above and I feel that they will return to haunt the euro zone. Whether they will be able to deliver on the numbers I do not know but I have my doubts. For example the main paymaster Germany is likely to be unhappy at the turn of events and we have already seen that her members on the ECB governing council voted no to the debt purchases.
As to the economics then the real issues here have not been addressed at all. The founders of the euro zone hoped for economic convergence. What we actually have at this time is economic divergence in economic growth, balance of payments, fiscal positions and inflation in the euro zone. These long-term problems lead to solvency problems and we have at best a liquidity solution.
In some ways ironically the IMF letter of intent to Greece has summed it up as it applies to much more than Greece.
The structural fissure is in weak competitiveness
and again referring to Greece it goes on to say
Risks to the program are high. The adjustment needs are unprecedented and will take time, so fatigue could set in. Any unforeseen shock could weigh on the economy and the banking system even if the fiscal program is on track.
Whilst not perhaps of the same scale of Greece several other euro zone countries have the same problem. So once the initial impact of this package has worn off I expect markets to concentrate again on the same list of unchanged problems.
Update 12:30 pm
There are two potentially troubling events happening today that I wish to draw your attention too. As you know I am concerned by the way that interbank markets have showed signs of freezing recently just like they did before Lehman Bros. hit trouble. Well today LIBOR rates have edges higher not lower. Whilst its own this is only a small move but a lot of effort has been expended over the past couple of days and one migt resonably have expected a fall….
Gold is rising today and is back above US $1200 and appears to be testing its highs from a few months ago on a futures basis. This is often a sign that people are concerned about events.