Tag: European Central Bank

Europe’s Money-Go-Round Saves the Day – for Now

Posted on January 19, 2012

European Central Bank (ECB) actions taken in December to counter a potentially devastating liquidity problem in the euro zone are gaining some traction, at least for now. The key step: making $650 billion in new money available to euro zone banks over three years under the Long Term Refinancing Operation (LTRO).

This week, for example, Spain sold one-year debt at a little more than half the rates markets demanded just last month, despite a recent downgrade of its sovereign credit rating. Also, the bailed-out banks have used some of their new-found capital – though not nearly as much as was hoped for — to buy up some European sovereign debt, further easing rate pressures.

The move came just in time. European banks last month were locked in a devastating credit crunch that could have brought the continent’s economy down hard. Banks were refusing to lend to each other, mostly over fears that sovereign debt held on the banks’ books could go bad. That could have caused some bankruptcies, and bank failures could have spread quickly.

The credit situation has improved, if only for the short run, thanks to the LTRO funding. But the big picture remains risky — and in some ways confusing — because of the unusual, circular way in which funds are changing hands between banks and governments. As The Economist noted recently, banks from Spain, Greece and Italy have the deepest capital shortfalls. “Several may have to tap government bail-out funds to raise the capital, creating the circular prospect of governments bailing out their banks that are in turn supposed to bail out the government.”

Similarly, Satyajit Das notes in this piece from the website Naked Capitalism, that French President Nickolas Sarkozy has urged banks to buy euro zone government securities, to be used as “collateral to borrow unlimited funds from the ECB or national central banks.” The French President noted that “earning 6% on Italian bonds that could then be financed at 1% from central banks was a ‘no brainer’….” Das adds that “Sarko-nomics perpetuates the circular flow of funds….”

So if money is simply on a merry-go-round, why have markets responded positively, if only in the short term? Notes Wharton finance professor Franklin Allen: “… Essentially they are trying to monetize the debt.” Since the Maastricht Treaty forbids the ECB from simply printing money and buying up debt, “this is an attempt to do the same thing by allowing the banks to borrow and then buy the debt.”

In the ongoing European debt crunch saga, all sides seem willing to use more debt to continue gambling on an eventual economic recovery that can reverse the tide. But with Europe now widely believed to be heading into – or already in – recession, many economies are shrinking and so are government revenues, and thus the ability to service all of this debt.

And the LTRO approach, while relieving the private and public credit crunch in the short term, carries significant new risks, Allen points out. “First of all, the banks are taking on risk. If there is a default on the government bonds they buy, they will likely go bankrupt. This is quite possible and this why so far they have been reluctant to do this in large quantities.” The ECB also is taking a risk – “if the banks go bankrupt, they will be technically insolvent. This will cause a significant political problem.”

In this article from The Telegraph, Ambrose Evans-Pritchard and Louise Armistead cite “nagging concerns over how long the ECB itself can keep shouldering the euro zone burden, given that it has no sovereign entity behind it. The LTRO … may save the day but it also concentrates risk further for the Bundesbank and other central banks in the euro zone system, as well as private banks. The ultimate disaster could be even worse if it all goes wrong.”

So far, while the LTRO has had the effect of lowering sovereign borrowing costs for some pressed European sovereigns, it has not yet accomplished another key goal – getting banks to lend to each other in a way that increases business and consumer credit. “We see that the key refinancing markets for banks are clogged; the interbank market is basically not functioning,” European Central Bank President Mario Draghi said this week, according to Bloomberg.

Meanwhile, some debt rating agencies have downgraded credit ratings for France and Austria. Both have lost their AAA rating this week, while Spain, Portugal and Italy were dragged down two more grades recently. Portugal’s debt is now rated at a junk-bond level. Spain’s credit rating was slashed from AA- to A shortly after it announced last week that it will miss its budget deficit target by about 33%.

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Europe’s Banks under Pressure. Are U.S. Banks Next?

Posted on November 23, 2011

The euro zone debt crisis is spreading to the real economy, banks and even German bonds as potentially catastrophic financial stresses continue to climb up in the absence of a comprehensive solution.

According to the latest economic reports, new orders for goods fell 6.4% in September compared with August within the zone, and overall economic growth stagnated at 0.2% in the third quarter, the same as in the second quarter.

Other reports noted that wholesale credit markets were tightening significantly for European banks out of concerns over their “creditworthiness,” as the Financial Times put it. The article quoted one money broker saying that lending markets have not been so stressed since Lehman Brothers collapsed three years ago. “There is plenty of money out there, but more and more banks are deemed too great a risk to lend to.”

There is a self-feeding frenzy about current conditions. As European sovereign bond yields rise, the overall market value falls for the large amounts of sovereign bonds held by many European banks. That makes it harder and more expensive for the banks to raise new funds, which can threaten their solvency. And all of this reduces the banks’ ability to invest further in sovereign bonds, which adds pressure on yields and pushes the cycle to repeat. Potential downgrades of government debt and the banks make matters worse. Now Standard & Poor’s has indicated that it could lower its credit ratings for euro zone countries if the region goes into a double dip recession, something that many see as highly likely in the New Year, particularly given the latest economic indicators.

Meanwhile, the stress on European bonds has spread not only to France, but also to Dutch, Finnish and even German bonds. In a separate article, the FT quoted one trader saying that rising German yields reflect worries “about Germany and the fact that many clients are now asking: ‘Is my money safe even in Germany if the euro is going to collapse? What will happen to my euro-denominated debt?’”

And of course, the stress on European banks ultimately gets conveyed to U.S. banks. Notes Wharton finance professor Franklin Allen: “So far, the focus in recent days has been on the sovereign debt market. But the focus should shift back to the banks soon. With current sovereign debt prices they are probably sitting on large losses on their government debt. A recession in Europe is quite likely, so the banks will come under increasing pressure. This will inevitably affect U.S. banks as they are all interconnected. The real question is what the ECB (European Central Bank) will do in terms of supporting the sovereign debt markets. If they don’t, then the likelihood of a Lehman-style — or worse — meltdown is significant.”

Others analysts also say that the only way to prevent a full-scale financial meltdown in Europe is for the ECB to announce it will become the lender of last resort for all euro zone debt. But the ECB itself, Germany and several other countries in the euro zone say they are dead set against that, and treaties setting up the euro zone forbid it. The new ECB president, Mario Draghi, says that the role of final guarantor of euro debt is not part of the ECB’s mission, and German Chancellor Angela Merkle was quoted last week in a speech as follows: “If politicians believe the ECB can solve the problem of the euro’s weakness, then they’re trying to convince themselves of something that won’t happen.”

Instead, the officials driving financial policy in Europe remain committed to austerity policies that they say will eventually improve liquidity and solvency issues for the troubled borrowers.

Whether or not attitudes would change about using the ECB as the lender of last resort — should a chain-reaction meltdown begin in Europe’s financial system — is anybody’s guess at this point. But any action at that point may be too late because of how quickly events can cascade.

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Is a Two-speed European Union Coming?

Posted on November 16, 2011

The serious threat to the world economy rearing up from the European Union’s inability to cauterize a looming financial crisis intensified Wednesday as the yields on Italian bonds again hit precarious highs.

Investor views of Italy’s ability to manage its sovereign debt have gone from concern to alarm in recent weeks, causing a demand for ever-higher yields on the country’s bonds. The higher yields have raised Italy’s debt obligations to a point where the country cannot service its debt unless it takes drastic measures to slash its budget deep into the bone.

Many analysts point out that with bond yields reaching 7% and higher, Italy would have to run a budget surplus of 5% of GDP or more to have any chance of reducing its total debt, which stands at 120% of GDP. Very few think the country could sustain such a huge hit to the economy — or the political fallout.

What’s needed, some analysts argue, is an overwhelming backstop – a final guarantor of euro-wide bonds for troubled countries like Italy. That would convince investors that there would be no defaults and would quickly reduce yields and thus funding costs. But the most effective potential agent for that role of lender of last resort — the European Central Bank (ECB) — does not have the support needed to act in that capacity, for a host of reasons that run from economic philosophies to political constraints.

The latest proof: German Chancellor Angela Merkel this week reinforced an earlier rejection of euro bond issues by the ECB. What’s more, her party – the Christian Democratic Union – has adopted a measure that would allow a euro zone member to leave the currency union without having to exit the European Union altogether. This would appear to build support for the idea of a “two-speed” Europe in which more economically competitive countries in the North might strengthen ties in a smaller euro zone that would — temporarily or permanently — exclude less competitive countries in the South, such as Greece, Italy, Spain and Portugal, which would remain members of a larger trade union. Whether or not this could be done in an orderly way or would lead to financial and economic disaster is subject to hot debate.

Last week Reuters reported that top officials in France, Germany and Belgium had been in discussion about the possibility of one or more countries exiting the euro zone “while the remaining core pushes on toward deeper economic integration, including on tax and fiscal policy.”

Wharton management professor Mauro Guillen notes that in many ways “the EU has always been two-speed — with 27 members, of which only 17 are in the euro zone. Now it seems the solution is to have fewer than 17 in the euro. It has become readily apparent that it is not working. The issue is how to shift from the present situation. The short-term pain might be great, but in the middle run, Greece, Portugal and others will recover. That is better that than a decade of stagnation.”

And from The Wall Street Journal, in its “Heard on the Street” column today: “Europe’s bond markets are in meltdown. What started as a manageable problem in Greece has reached the heart of Europe. As investors lose confidence, bonds may be starting to price in extreme outcomes such as a euro-zone break-up. The more they do so, the more likely these outcomes become, as higher yields increase financial stress. The crisis is feeding on itself.”

Find more coverage on the crisis in Europe and how it could affect the world economy in these recent Knowledge@Wharton articles.

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Manila or Bust?

Posted on February 11, 2011

As EU leaders wrangle over whether and how to give the 440 billion euro ($600 billion) European Financial Stability Facility (EFSF) more lending powers at next month’s summit, there has been no shortage of proposals in recent weeks about how best to get Europe out of its debt mess.

One increasingly popular idea for dealing with Europe’s debt crisis is to let Greece, and possibly Ireland and Portugal, essentially default. “Default is no longer unthinkable,” says Wharton finance professor Richard Marston. “I am increasingly convinced that both Greece and Ireland will have to do this. Look at the credit spreads. They are telling you that the markets expect a default. But a lot depends on how it is done.”

Another proposal is debt forgiveness, as Paul De Grauwe wrote in a January policy brief from the Centre for European Policy Studies. So rather than subjecting, say, Ireland to the “punitive interest rates” of 6% as part of its EFSF package — which the country will struggle to pay — the fund could charge 3.5%, which is the interest rate Germany pays “plus some ‘gentle’ risk premium,” thereby substantially reducing the fiscal effort Ireland would need to stabilize its debt ratio (likely to be around 110% of GDP by the end of this year) and lower the default risk. The challenge there, of course, is convincing creditor countries to provide the liquidity.

For Greece — the first country to turn to the EFSF last year — a solution said to be under consideration is what German news publication Spiegel calls “the Manila model,” reportedly named after a plan used in the Philippines in the 1980s. The voluntary Manila plan gives investors a choice: If they accept Greece’s discounted bonds (which would be bought back using an EFSF credit line), they have to book a considerable loss, but at least they would know that the losses would not be even greater. If they don’t accept the bonds, they agree to accept the risk of Greece becoming insolvent.

Marston says the Manila model “is an intriguing one because it lets the market set the terms at which Greece or any other country restructures its debt.” As he points out, there is already a huge discount on Greek debt — reflected in the huge interest premiums over German government bonds — so the restructuring would lower the debt burden substantially. What’s more, “the costs of such a buyback would be borne by the banks holding the debt.  So there are still pressures to avoid a writedown,” he notes.

Wharton finance professor N. Bulent Gultekin believes Greece could indeed end up with some sort of debt swap. “If lenders accept a flat discount, the [European Central Bank] or any entity will issue new bonds backed by their guarantees, and then speculation about a Greek or Portuguese default will disappear.”

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