Monday, October 10, 2011

Today's links

1--The Ticking Euro Bomb; What Options Are Left for the Common Currency?, Der Speigel

Excerpt: The nations of the euro zone are in debt to the tune of €8 trillion, while banks hold European government bonds at a face value of €1 trillion on their books. The central banks of Greece, Italy, Portugal and Spain owe Germany's Bundesbank €348 billion. The ECB has purchased €150 billion in government bonds, and the banks, fearing loan defaults, would rather park up to €150 billion with the ECB than lend money....

The Euro Is a House without Keepers

This highly explosive network of mutual dependencies makes the euro unstable in times of crisis. But it becomes vulnerable and truly dangerous as a result of a unique feature that distinguishes it from the dollar, the yuan and all other currencies: The euro is a house without keepers, a currency without political protection, without a uniform fiscal policy, and without the ability to forcefully defend itself against speculative attacks.

For a monetary union to function, the economies of its member states cannot drift too far apart, because it lacks the usual balancing mechanism, the exchange rate. Normally a country depreciates its currency when its economy falters. This makes its goods cheaper on the world market, allowing it to increase exports and thereby reduce its deficits. But this doesn't work in a monetary union. If one country doesn't manage its economy effectively, the common currency acts as a manacle.

If Greece were a state in a United States of Europe with a common fiscal and economic policy, it would be just as protected as the city-state of Bremen, also deeply in debt, is by the Federal Republic of Germany. But because there is no common European fiscal policy, Greece, as the weakest country in the European Union -- and despite the fact that it only contributes three percent to the total economic output of the euro countries -- becomes a systemic threat for 16 countries and 320 million Europeans. And the euro, intended as a means of protecting Europe against the imponderables of globalization, becomes the most dangerous currency in the world....

"The current policy is to act as if a liquidity crisis could be overcome," says Rogoff, "and as if all it took were to hand out enough loans to jump-start growth once. But it's the wrong diagnosis. We have a solvency crisis, and we have European countries and regions that are fundamentally bankrupt. No loan in the world, no matter how big, will save Greece, nor will it save Portugal and probably not Ireland, either, and Italy is also very worrisome."

Band-Aids Where Surgery Is Needed?

If this conclusion is correct, it means that the new European Financial Stability Fund (EFSF), established for ailing euro countries, is pointless. It means that the ECB's new policy of financing the national debts of countries will fail. It also means that Europe's leaders, as they rush from one crisis meeting to the next, are merely handing out Band-Aids where surgery of the inner organs of the Union would be necessary. "The goal now should be to trim debt," says Rogoff, "declare bankruptcy and start over again." According to Rogoff, Greece is so insolvent that it will only have a future if 50 to 75 percent of its government debt is written off, and the situation in Ireland and Portugal isn't all that different.

2--Austerity Bites, Wall Street Journal

Excerpt: Governments at every level shed 34,000 jobs last month, the Labor Department said Friday. The private sector, meanwhile, added 137,000 positions (about 45,000 of which came from returning Verizon Communications Inc. employees).

The cutbacks primarily came from local governments, though the turn toward austerity at every level of government has some liberals worried reduced government spending will depress growth at a time when the economy is already struggling. Conservatives contend that existing and projected federal deficits hinder economic growth and now is the time to start reining them in to reduce uncertainty.

“With downward pressure on government payrolls likely to persist (particularly at the state and local level, although soon at the federal level as well), it is important to look at the overall nonfarm payroll results rather than just those for the private sector,” Joshua Shapiro, chief economist for MFR Inc., wrote in a note to clients.

Local governments, which continue to struggle with depressed tax revenue and declining aid from state governments, trimmed 35,000 jobs in September from a month earlier, mostly in education.

In the past year, localities have cut 210,000 jobs. The pain is unlikely to ease soon, city finance managers noted in a recent survey.

“The effects of depressed real estate markets, low levels of consumer confidence and high levels of unemployment will continue to play out in cities through 2011, 2012 and beyond,” the report found. “Lower property values and declining sales may portend something entirely new, a ‘new normal.’ ”

Friday’s report held a glimmer of hope for state governments, which added 2,000 jobs in September after adding 11,000 in August. Still, states have shed a net 49,000 public-sector jobs in the past 12 months.

Federal government job losses in September came entirely from the U.S. Postal Service, which eliminated 5,300 jobs. Excluding the Postal Service, other corners of the federal government added 4,000 employees.

States and localities have already gone through a barrage of spending cuts to balance their budgets but the brunt of federal spending trims haven’t been implemented yet.

Discretionary federal spending is expected to decline in fiscal years 2012 and 2013. The magnitude of such cuts is likely to become clearer by Thanksgiving, when the so-called super committee releases its recommendations to reduce the federal deficit.

3--France, Belgium, Luxembourg agree Dexia rescue, Reuters

Excerpt: France, Belgium and Luxembourg agreed a rescue plan for Dexia SA on Sunday ahead of a planned board meeting expected to decide on a break-up of the first lender to fall victim to the euro zone crisis...
The burden of bailing out Dexia led ratings agency Moody's to warn Belgium late on Friday that its Aa1 government bond ratings may fall.

The negotiations to dismantle Dexia, which has global credit risk exposure of $700 billion -- more than twice Greece's GDP -- are being watched closely for signs that Europe might be capable of decisive action to resolve its banking crisis.

"I am convinced that it is possible ... by tomorrow morning to have an agreement in which Belgium resolves the issue without pushing up the debt level of our country too high," Leterme told Belgian television before the talks began on Sunday.

Dexia, which used short-term funding to finance long-term lendings, has found credit drying up as the euro zone debt crisis worsened. This problem has been exacerbated by the bank's heavy exposure to Greece.

Dexia's near collapse stoked investors' anxieties about the strength of European banks and coincided with growing talk about coordinated EU action to recapitalize banks across the continent.

A 'bad bank' supported by state guarantees will hold 95 billion euros in bonds, including 12 billion euros of sovereign debt of weaker euro zone periphery nations.

Including 7 billion euros of securities linked to U.S. mortgages, France and Belgium may need to provide guarantees to cover up to 200 billion euros of assets, which would be more than 55 percent of Belgian GDP.

4--U.S. Banks May Have $640 Billion in Europe Exposure: Congressional Researchers, Barrons

Excerpt: A paper produced by the Congressional Research Service, a government agency that does research for members of Congress, attempts to quantify U.S. banks’ exposure to the European debt crisis. The estimate is rough and could be quite a bit off, but it is one of the few times that anyone has actually tried to pin a number on bank exposure to the crisis.
“Given that U.S. banks have an estimated loan exposure to German and French banks in excess of $1.2 trillion and direct exposure to the PIIGS valued at $641 billion, a collapse of a major European bank could produce similar problems in U.S. institutions,” the paper says, according to the Wall Street Journal.

The figures come from a unit of the Federal Reserve called the Federal Financial Institutions Examination Council, and include direct holdings like loans and “other potential exposures”, the Journal notes.

Those “other potential exposures” encompass derivative contracts, guarantees and credit commitments, among other things. Unfortunately, that calculation is inherently unreliable, because it doesn’t take into account the possibility that a derivative contract is hedging against another exposure, for instance.

5--Europe's QE may pose problems, China Daily

Excerpt: A new round of monetary-easing measures in Europe has boosted investor confidence in the capital market, but may bring more difficulties for China's policymakers in terms of tackling inflation and the inflow of "hot money", said economists.

On Thursday, the Europe Central Bank (ECB) decided to hold its key interest rate at 1.5 percent and offer emergency short-term loans to the continent's battered banks which are facing difficulties in borrowing because of concerns about each other's financial stability...

However, good news for the Chinese capital market may not be beneficial for the country's macro economy, said Yuan Gangming, a researcher at the Center for China in the World Economy at Tsinghua University in Beijing.

"The QE by Europe's central banks has helped China's stock market to dodge a major shock during the holiday," said Yuan. "But on the other hand, it is also a way of exporting their trouble to the rest of the world."

As Europe injects liquidity into the global market, the "prudent" monetary policy adopted by China's central bank is likely to invite more inflows of hot money, adding more pressure to the country's inflation, Yuan said.

Yuan suggested that the central bank should begin to adopt loosening measures to ease external pressures and the tensions on the domestic credit chain, which is already fragile in the light of the financing difficulties faced by many private businesses.

6--Europe up a creek with no central bank, Reuters

Excerpt: Europe is demonstrating that a sovereign nation without a true central bank is just an uninsured bank, liable to be tipped over by the markets.

While the ECB is a central bank in almost all respects, what it isn’t is a lender of last resort for individual euro zone nations, a role that is expressly ruled out by the European Treaty.

A lender of last resort is what stops a bank run on a solvent institution from bringing it down due to a lack of liquidity. In the case of a nation, a lender of last resort, usually the central bank, can simply print money to satisfy debts in its own currency. And though we’ve all become terribly cynical about the concept of liquidity crises in the past couple of years, not least because so many people in authority have used it as a place to hide when the real issue was solvency (Greece, Lehman Brothers), the fact is that markets take on their own momentum.

Just as no-one viewed euro zone debt as anything other than a safe haven for the currency area’s first decade, now investors are busy driving up the price of even German default insurance.

This is the terrible logic of markets when they view sovereign borrowers as credit risks; it is almost inevitable that they push, and in pushing weaken the un-backstopped borrower and ultimately bring it down. This is a process which needs a circuit breaker, and Europe has no adequate circuit breaker, unlike Britain or the U.S.

“Rather than viewing government bonds as risk-free, safe-haven assets, financial markets now view and trade euro area sovereigns mainly as credit risks. This has very profound consequences for the stability of financial markets,” economist Elga Bartsch of Morgan Stanley wrote in a note to clients.

“For it seems to me that some markets have lost their ability to find a new, stable equilibrium. This is because, instead of moving in sync with the business cycle, government bond yields now move against the cycle, ie, rising in a downturn. This seriously undermines the ability of the government sector to stabilise the economy and the financial sector.”...

The ECB has purchased government bonds as a back door means of providing support, but this is awkward, will ultimately test the limits of the bank’s capital and, as being against the spirit of EU law, is deeply divisive. The EFSF fund is not well suited for playing this role either.


You could object that, of course, all sovereign borrowers are ultimately credit risks. Even if one is repaid in the sovereign’s currency, that currency can be debased by inflation or the money printing press. True, but markets do not seem to impose the same penalty on inflation risk that they do on default risk.

There are two main take-aways from this. The first, of course, is that if you don’t have a proper central bank you ought to keep your debt profile slim so as not to attract too much attention to your vulnerability. This worked for Germany, whose Bundesbank was similarly forbidden by charter from printing money to buy government debt. Not borrowing too much is good advice but not terribly helpful in the current circumstances.

The second is that Europe needs a democratic way in which to agree to monetize or otherwise write down its debts. Failing that, the risk is that the domino-style run on government credit becomes self-fulfilling, as we’ve seen is the risk with ever larger sovereign borrowers like Italy being weighed by the markets and found wanting. This ultimately will break the euro, probably at about the point when Germany realizes it is picking up France’s dinner check....

7--ECB Says Banks Increased Overnight Deposits to 15-Month High, Bloomberg

Excerpt: The European Central Bank said banks increased overnight deposits to the highest level in 15 months.

Euro-region lenders parked 229 billion euros ($307.6 billion) with the ECB last night, up from 221.4 billion euros the previous day. That’s the highest since July 6, 2010. Banks borrowed 1.8 billion euros from the ECB at the marginal rate of 2.25 percent, down from 3.2 billion euros.

8--US Consumer Credit Fell $9.5 Billion in August, Biggest Drop in a Year, Bloomberg

Excerpt: Consumer credit in the U.S. unexpectedly dropped in August by the most in over a year.

The $9.5 billion decrease followed an $11.9 billion increase the previous month, the Federal Reserve said today in Washington. Non-revolving credit, which includes student loans and financing for automobile purchases, slumped by the most in three years.

Decreasing credit shows American households are either continuing to pay down debt or lack the confidence to boost spending on non-essential goods. A thawing of credit and a faster pace of purchases may require bigger gains in income and payrolls.

“Consumers were cautious over taking on additional debt at the end of the summer after the volatility in the stock markets and the uncertainty caused by the failure of Congress to work together to bring down these trillion-dollar deficits,” Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, said before today’s report....

Non-revolving debt, including educational loans and loans for autos and mobile homes, dropped by $7.23 billion in August, the biggest decrease since Aug. 2008. Revolving debt, which includes credit cards, fell by $2.27 billion. The report doesn’t track debt secured by real estate, such as home equity lines of credit and home mortgages.

9--Three-Month Dollar Libor Rises for 21st Day, Reaches 0.39111%, Bloomberg

Excerpt: The rate at which London-based banks say they can borrow for three months in dollars rose for a 21st day, reaching the highest level since August 2010.

The London interbank offered rate, or Libor, for dollar loans climbed to 0.39111 percent from 0.38778 percent yesterday, according to data from the British Bankers’ Association. That’s the highest rate since Aug. 10, 2010.
The dollar Libor-OIS spread, a gauge of banks’ reluctance to lend, widened to 30.51 basis points at 12:07 p.m. in London, from 29.98 yesterday.

That’s the widest on a closing-price basis since July 23, 2010, according to data compiled by Bloomberg.

The TED spread, or the difference between what lenders and the U.S. government pay to borrow for three months, widened to 39.11 basis points after reaching 38.27 basis points yesterday, the highest level since June 29, 2010.

10--Europe’s new credit crunch, eurobserver

Excerpt: ...EA Parliaments dither about just how the EFSF’s limited capital can be stretched to meet the bill. Since the €440bn available cannot be miraculously turned into the €2tn required for ‘shock and awe’ to be sure of succeeding, the latest twist involves turning the EFSF from a lending institution into a insurance company, in effect selling credit default swaps (CDSs) to those most in need of insurance. These would be structured into equity, mezzanine and senior layers just like their Wall Street cousins, thus enabling €440bn to be hugely leveraged.

But as more than one commentator has pointed out, there are several problems here. First, one is using over-leveraged instruments to deal with the problem of over-leverage. Second, there is no ‘lender of the last resort’—if the scheme goes wrong, governments cannot bailout the losers since it is governments who hold the equity tranches. In principle, the ECB could perform this role—but the Germans are resolute in their opposition to the ECB acting as a Central Bank for governments. [2] For that matter, tiny Slovakia is threatening to upset the EFSF applecart unless collateral is provided for its pledged assistance.

An obvious way out of this nightmare would be to forgive Greece at least half its debt (which the markets believe is in any case unpayable) while further reducing the interest on its loan, lengthening its debt maturity profile and aiding the country to become more competitive. Cynics might say this has been obvious from the start, and that it is now too late. If a European financial crisis does not happen next week, it will occur as part of a disorderly default in December when the pain finally becomes too much for Greeks to bear. It is then that we shall all feel the pain of a full-blown financial crisis, most probably followed by more years of economic recession.

11--As bank shares tumble, the scale of the financial shock becomes clear, New Statesman

Excerpt: Worryingly, things are likely to get much worse - and fast - in the eurozone and the wider banking system. In recent weeks, the Franco-Belgian bank Dexia SA has sunk deeper into trouble. With a portfolio of loans and bonds reaching €651bn (£562bn) - many times its relatively small retail-deposit base, centred in Belgium and Turkey - the bank is a major holder of sovereign debt from the eurozone's fragile periphery.

Following the collapse of Lehman Brothers in 2008, the authorities in France, Luxembourg and Belgium injected €6.4bn (£5.5bn) into Dexia but the bank may now need rescuing again. At the time of writing, on 4 October, Dexia's shares had fallen sharply (by more than 20 per cent) for a second consecutive day and the finance ministers of France and Belgium made a statement that they would support the troubled bank, amid signs that it
could be broken up.

Over the past year, the share prices of French and German banks have been hit by fears of their exposure to Greece and the other peripheral countries in the European Union. The four main banks involved are down from their 52-week highs as follows: Société Générale by 66 per cent, Crédit Agricole by 63 per cent, BNP Paribas by 54 per cent and Deutsche Bank by 50 per cent....

Osborne's mettle will be tested when Greece defaults, as it surely will. I recall how he and Cameron opposed the rescue of the banks in 2008 without telling us what they would have done instead. The former chancellor Alistair Darling made clear recently that, on 7 October 2008, the then chairman of RBS, Tom McKillop, called him to say that the bank would run out of money in two hours and wouldn't last the day if the government didn't step in with a rescue plan. I hope we won't have to find out how Osborne would respond to a comparable crisis but the markets appear to be expecting just that. One down, all down.

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