Europe’s politicians prepare to make some more financial fudge, will they ever learn from their mistakes?

After discussing China’s situation yesterday in terms of her plans for reserve requirements and her inflation problems it would appear that events have taken a further step forward this morning. The financial world is awash with rumours that China is on the verge of raising her interest rates and the Chinese Shanghai Composite Equity index has  fallen by 5.2% in response to these rumours and the knock-on effects are being felt around the world. The Japanese Nikkei 225 fell by 136 to 9724 and European equity markets opened very weakly although the FTSE 100 has now recovered to be only 1.1% down. It is also true that the lack of any real progress at the G-20 meeting may have influenced markets although I doubt much was expected as the differences between the countries present was and is simply too great.

G-20 Communique

I have written before about the dangers of what Brazil’s finance minister called “currency wars” which in the worst case could lead to the type of competitive devaluations that contributed to the economic crises of the 1930s. The response of the G-20 in its statement can be summarised as follows.

“Uneven growth and widening imbalances are fueling the temptation to diverge from global solutions into uncoordinated actions……….Uncoordinated policy actions will only lead to worse outcomes for all.

This is an odd statement because for example the United States has been following a policy of tacit US dollar devaluation since this summer, Japan has been trying to devalue her currency since she began intervening on September 15th, and of course the Chinese have been running an undervalued currency for some years. These are precisely the sort of uncoordinated policy actions the statement talks about so I can only presume the leaders will return home and resume doing what they have just criticised! It is a bit like their attitude to global warming where they criticise other behaviour but then are happy themselves to travel around the world to meeting which usually achieve little.

One possible gain from the meeting is that it will allow EU leaders to sit down out of the glare of publicity and discuss the rapidly developing crisis which is threatening to engulf Ireland and Portugal.

The Crisis in the Euro Zone

If we step back for a moment and consider the implications for the Euro and the institutions that support it then we can see that this stage of the crisis is beginning to pose fundamental questions for it and them. When the Greece crisis reached its peak in late spring it was possible for the EU to get together the funds it felt it required to deal with the situation, I wouldn’t say without problems but Greece is only a small part of economic output for the area as a whole and so the scale of the rescue was relatively small. Now the Euro zone is facing having to do the same for Ireland and Portugal. Whilst in terms of relative economic size these are again relatively minor players  it is only 6 months or so after the Greek debacle that we are seeing real contagion with 2 more sovereign states in trouble.

The problem that we immediately hit is that the two solutions to the problem that the Euro zone came up with are flawed.Back in May measures were instituted in a panic which were not thought through. They may have been an answer to the political crisis allowing politicians to proclaim victory and display hubris but this type of short-term solution only kicked the can 6 months down the road. So the dose of Euro fudge was initially sweet but has turned out to have sickly after-effects

The Securities Markets Programme

 The Securities Markets Programme where the European Central Bank buys debt in the countries which have “disequilibrium” has spent around 64 billion Euros since it was invented in early May.The problem is that it was no real objective and is if you like a programme which responds to panic in markets.Accordingly it has been unable to get ahead of events and spends its time chasing the markets tail. Unfortunately if you think about it you see a situation where it must have two problems, firstly it has accumulated losses as virtually every purchase in Ireland and Portugal must be loss-making at this time, and secondly it has built up a balance sheet of what are considered to be assets of low credit value. So the SMP is revealed as a programme which poses dangers to the ECB’s balance sheet, and is therefore potentially a problem for Europe’s taxpayers. Also it has led to divisions within the ECB itself. If we go back to early May the ECB had a meeting where it claimed it did not even discuss this subject then four days later it found itself corralled into it by Euro zone politicians. One effect of this was to split the ECB into two camps as some are still critical of the SMP which hardly increases credibility.

The European Financial Stability Facility

This is perhaps the most flawed institution of all. I serious wonder if it will even work if it is called on and it will at best be slow and unwieldy. I suspect under the hype and hyperbole Europe’s politician’s genuinely believed that the announcement would be enough and that it would never need to be actually deployed.

The first  flaw is that it is a bilateral agreement between the 16 Euro zone nations. This means that those in need of aid drop out of providing funds. Then we see that countries in effect have to raise their own share of the funds with the EFSF doing that for them and to achieve a AAA credit rating it holds back some 20% of its theoretical funds. So by my maths of the 440 billion Euro’s hyped we are now down to around 336 billion. Next we hit the fact that the bonds which need to be issued will by definition be done at a time of crisis, what if markets are unwilling to in effect lend to countries on the terms suggested? Let me give you two examples where they might say no, Spain and Italy. So the funds might shrink again. Also if you think of timing all this will take time when an urgent response is likely to be needed and could go on and on. Just to put the icing on the cake some now think that for it to work it would have to raise the interest-rate it charges from the originally anticipated level which was around 5.25%.

There has been speculation by Wolfgang Munchau that the interest rate charged could be 8%. Should he be correct then the solution to sovereign nations having long-term interest rates which make them insolvent is to charge them an interest-rate which makes them insolvent! Should he turn out to be correct this may be an entry in the most incompetently designed international agreement.

Personally I do not feel that it will charge 8% and will remain around 5 to 5.5%% but the size will be much smaller as it will in effect rely on what Germany and the core Euro zone countries are willing to raise. So I would suggest that the size might turn-out to be more like 200 billion Euros. Of course this relies on these nations being willing to do this as their politician’s may find that their voters are much less enthusiastic about the implications of this.

Ireland and her deepening crisis

The impact of this crisis has hit Ireland and her government bond yields hard. Her ten-year government bond yield closed last night at 8.8% and even her bond which expires in January 2014 now yields over 8%.Ouch.Through the crisis I have argued that her shortest dated bond is significant as it has a year to go and it now yields 5.68%. It is significant because the ECB official interest rate is 1% and it is the gap between the two or 4.68% that matters. Whilst the ECB will not officially give you money at 1% for a year does anybody really think that if it was contacted by a buyer of Irish bonds that it would say no? Some deal would be done. It would appear however that few want to take the risk.

Consequences

Some argue that as Ireland has reserves she can afford to let the storm pass as her government can use the reserves for around the next 8 months or so. I think that this is flawed thinking because what will individual’s and companies do? What if they wish to borrow? If you consider the position of what Irish fixed-rate mortgages must be priced at or what interest-rate her companies would borrow at and hence the return which would be required if investment would be economic I hope my point becomes clear. This is exactly the sort of situation which caused the 2008 recession. She is in danger of an interest-rate driven economic shock which from her weak starting position would have 1930s type consequences.

Let me give you a concrete example of this back on the 28th of October I wrote this about some borrowing by the Bank of Ireland ( just to be clear this is a commercial bank with a confusing name not the central bank).

Another is that Bank of Ireland has issued Euro 750 millions of 2 and a half-year borrowing, on the face of it this sounds good and maybe you will find some journalists who say this. However if you stop and think that this money has been borrowed at 5.9% you then get two very worrying thoughts.

1. Exactly where is Bank of Ireland going to be able to lend this money out at a profit when interest-rates are so low? In case you are wondering its standard rate for mortgages in Ireland is 3.4%. So any new mortgage business is at a margin of -2.5%.

2. Bank of Ireland has a state-guarantee so the fact that it has had to pay 5.9% for relatively short-dated borrowing is worrying for the sovereign nation too

This troubled me at the time and if you factor in the fact that sovereign yields have shot up since then the rate now would be perhaps 2 points higher if anyone would lend at all. Those who have actually purchased this paper may well be crossing their fingers and putting it in their hold to maturity book (if there is room….) as so far it has lost 10% of its value which for such a short-dated bond in such a short space of time is quite an achievement. It will hardly encourage them to return.

A possible UK Consequence

There is an anomaly in the UK whereby Post Office Savings are actually provided by Bank of Ireland. If we put the dangers of this to one side perhaps there is some hope for better interest rates for them as for the Bank of Ireland it might be a relatively cheap way of getting some deposits.

Comment

Financial markets ebb and flow and today is likely on its own to see something of an improvement. The Euro zone politician’s are likely to try to come up with something and if you are a sophisticated investor you are likely to want to take your profits and get out of the market as this weekend carries a lot of political risk. All sorts of rumours are flying round about what is being proposed in Seoul as I type and Irish government bond yields are falling.

However in the hubbub and excitement please keep in the back of your mind that so far Euro fudge has proved to have an initially sweet taste but then sickly after-effects emerge.

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19 thoughts on “Europe’s politicians prepare to make some more financial fudge, will they ever learn from their mistakes?

  1. Hi Shaun; “her bond which expires in January 2014 now yields over 8%.Ouch.Through the crisis I have argued that her shortest dated bond is significant as it has a year to go and it now yields 5.68%. It is significant because the ECB official interest rate is 1% and it is the gap between the two or 4.68% that matters.” This is of course increasingly significant. Indeed this is a present phenomenon which exists now in many Western countries, even with normal retail savings rates. The “official” rate in many currencies no longer seems to set or influence the actual market rate discernibly, since there has become a more marked detachment than I can ever recall seeing before in my lifetime so far. The spread is now as much around 700 % or more which I find to be quite amazing.

    “…Post Office Savings are actually provided by Bank of Ireland. If we put the dangers of this to one side perhaps there is some hope for better interest rates for them as for the Bank of Ireland it might be a relatively cheap way of getting some deposits.” Well of course the bad risk presented by this must have been seen by The Bank of Ireland, since it has re-registered it’s operations in the UK with the FSCS from 1st November by forming a UK subsidiary of The Bank of Ireland. This now gives UK backed cover for retail depositors of up to £50 000 (Euro 100 000 wef January 2011). The Post Office deposit rate has also been increased to 2.99 % pa, so I think you are correct in seeing this move as one to capture more retail funds, at a less costly rate than bonds, from the UK via The Bank of Ireland.

    It still astonishes me that the UK government evidently does not see the UK retail deposit market as a source of cheap finance for their debt? Even with current UK guilt yields this source could offer savings, let alone if gilt yields should increase.

    • DRF: “It still astonishes me that the UK government evidently does not see the UK retail deposit market as a source of cheap finance for their debt? Even with current UK guilt yields this source could offer savings, let alone if gilt yields should increase.”

      I feel the UK government would be robbing Peter to pay Paul if they tried to do this directly, as they would only have to provide more support to the banks as UK investors moved their funds around.

      Secondly their are many stuck-in-the-mud NS&I investors who are being paid very little. Paying new investors more would not help the UK’s finances, as existing investors would cash in their bonds and move their money into the new NS&I investments.

      • “I feel the UK government would be robbing Peter to pay Paul if they tried to do this directly, as they would only have to provide more support to the banks as UK investors moved their funds around”

        Exactly. NS&I has a funding target set by the Treasury to ensure it doesn’t impact too greatly upon other deposit seekers:-

        “NS&I operates in the retail savings market and must reflect the impact it has on the banks and building societies. In setting their target for funding, and therefore the rates on their products, the Treasury and NS&I must balance the interests of savers, taxpayers and the impact on the wider market in terms of stability and competition.”

        In this year’s 2nd qtr, NS&I blasted through this target, hence a bunch of products were withdrawn (such as Index Linked Savings Certs) and rates reduced on others.

      • Hi Jonathan and Trevor; so you, presumably as UK taxpayers, are happy that the government should waste the opportunity to save UK taxpayers’ money by reducing their cost of borrowing. Well as a UK taxpayer myself at present, though not for much longer I hope, I do not agree with you.

        Perhaps you did not see the Channel 4 documentary broadcast last night concerning the way in which successive UK governments have wasted and continue to waste the money of UK taxpayers to ensure that the UK will be erased from the economic map of successful nations soon? If so you can watch it now on the link:
        http://www.channel4.com/programmes/britains-trillion-pound-horror-story/4od .

        However, if you believe in Socialism like Brendan Barber in this programme, you will clearly reject all reality and truth. There have been a number of Left-Wing articles already today disputing the truth demonstrated in this programme, but they do not make any attempt to address the fact that Hong Kong has prospered whereas the UK is in terminal decline! Cameron of course represents an essentially Left-Wing view, so he also does not have the slightest understanding of the facts presented in this programme.

        The issue here is of course the servicing cost of funding the UK debt. Despite your comments, and despite such an artificially low base rate as we currently have, it would be cheaper to fund part of it from retail deposits than at current gilt rates, and this is likely to become even more true quite soon, the way things are going.

      • Hi DRF,

        If you are absoluteley sure that the UK government undercutting the UK banks to the point that the only possible savings vehicle is entirely state owned is the best way to prevent socialism, I’m all for your plan.

  2. Hi and thanks, Shaun. On the EFSF I agree it looks a mess. On the interest rate Mr Regling had previously reckoned that it would be c. 2% ( equivalent triple A sovereign) plus 300 bps = c.5%. Plus an arrangement fee. Where does the 8% come from?

    If and EFSF bond is issued to support a sovereign, what would happen to that sovereign’s banks’ funding costs?

    Of similar concern would be the 440 billions – if two or three sovereigns call on it, how could it react.As sovereigns take loans they fall out of the guarantee to the fund, so Germany and France and Italy and Spain take a bigger strain?How does that go down? It could also have to issue its bonds at different maturities for differing sovereign loans. Maybe the IMF will end up having to play a leading role in support anyway.

    Regarding Ireland’s reserves, does anyone believe they would leave forward funding arrangements drift to the point where the reserves run out? Not credible surely.

    • Hi Shire
      I think that with some concepts it is best to quote a maximum and then offer an opinion. For example with Ireland she could probably survive until June 2011 but I have written and suggested since September 19th that she should call in the IMF and as I have repeated today I think that any delay was and is an error. Having got some IMF funding Ireland would then have a fair degree of flexibility to deal with and negotiate with Europe. This would give Europe some time to modify the EFSF which sorely needs it.

      As to the interest rate I agree with the principle of your calculations and calculated 5.23% not long after the EFSF began and although there is a variable element didnt expect a lot of change. So I was a little surprised to see 6% quoted and even more surprised to see 8%. I have tended to think about it the other way as in the interest rate will be similar to what was expected but the number of countries which can raise the money will be much fewer than expected. So the amount of firepower it has will be roughly halved rather than the interest rate rising. My understanding is that the higher rate comes from allowing for the ability of the weaker nations to raise money.

      As to your question about bank funding costs the only similar test case we have was for Greece. In her case things got better for around a fortnight and then funding costs went higher again. There has also been a lot of reliance on funding from the ECB in the Greek case which implies that for periods the Greek banks have found the interbank markets to be closed.

      I would imagine that right now someone from the ECB is pointing out the flaws in the EFSF and the fact that the ECB is split over the SMP. Perhaps their eyes with go to the 60 billion Euro’s they took from EU funds for this purpose as they have it and it should be available. With the IMF there should be enough money to settle Ireland but it would then perhaps require some crossd fingers that Portugal does not need bailing out for a bit ( or perhaps the SMP could major on Portuguese debt)…

  3. Shaun, you mention the risks to Europe’s taxpayers from the low quality assets the ECB is building up on its balance sheet. I read a suggestion in a FT comment that the long-term German plan may be to leave the euro, in which case the remaining members would be left with the problem. In these circumstances, I guess the Austrians, Dutch and Finns would also leave. Presumably, the whole rump euro-zone would then default? I guess a trigger for this could be if the judges of the German constitutional court find the Greek bail-out illegal, since leaving the euro would be the only action open to the German authorities to comply with the judgement. Do you have any views on the economics of this scenario?

    • Hi Ian
      There would be a few consequences of Germany leaving the Euro. Firstly I would expect the other core countries to leave as well. I do not know whether they would go with her or over time but a strong DM and German based interest rates would suit the countries that you list. However we have the problem of the EU’s institutions which in the main depend on Germany’s credit rating and her willingness to pay into the EU.

      A “rump” ECB would look a very dodgy beast without Germany’s implicit backing and if the other core nations went too then it would be in trouble. This would lead onto problems for the remaining countires as follows. A falling exchange rate as the Euro adjusts which might give them a short-term boost but would also be inflationary. There would be higher government bond yields as they lose the “umbrella” that Germany has thrown over the Euro. For some there would be no German financed subsidies. So all in all not a very welcome picture but if you go back 10/20 years perhaps not so unfamiliar for many of the countries.

      I think before she left Germany would have to assume responsibility for some debts at the ECB and so on which would buy some time.

      I would not expect an immediate default as the politicians so far have always fiddled whilst Rome burns to coin a phrase. But the Euro fall would raise serious problems for countries with substantial overseas creditors…

      As these are a reasonable proportion of her export markets Germany does not want this scenario to play out and so for that reason she may threaten it but is unlikely to do it, for now anyway….

  4. I agree with Drf, its madness not to use retail deposits to fund government borrowings. I would go further and advocate nationalising the banks we almost own, that way instead of that QE money disappearing, if we had to print, it could be directed at sectors which would provide economic stimulus, such as SME manufacturing. Arguing that it would distort the private banking sector is anomalous, the situation now is that we are going forward with a loaded gun at our heads held by institutions ‘too big to fail.’ Can someone say what economic philosophy that belongs to?

    Further afield I think we need to consider the paradigm shift which is occurring in far flung corners of the world. It was fine, if short-sighted, to outsource work to these places when indigenous expectations were low but now we see even these workforces wanting their own BMW’s, plasma screen TV’s and home ownership. It’s about the transfer of ‘wealth’ from West to East and the ensuing restructuring needed here. With the likes of China buying continuation of supply in the likes of rare commodities pretty soon they will be using it to supply their own domestic markets and I don’t think we can come up with the grub stake needed to take part in that particular poker game!

    We need a government to take bold steps towards a dynamic rationalisation of socio/economic factors but instead we get them falling back into their own ideological trenches, because in all honesty it is probably the only place they are comfortable in!

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