by Cliff Wachtel, FX Empire
Everything you need to know about biggest threat to markets for the foreseeable future-why EU bank supervision can’t be avoided, but risks so much
The following is a partial summary of conclusions from our weekly fxempire.com analysts’ meeting for the week ending 15 November 2013 in which we share thoughts and conclusions about the biggest potential “under-the-radar” drivers of global currencies, equities, commodities and bond markets for the coming week and beyond.
The following is important for more than just the coming weeks, so pay attention.
Janet Yellin’s testimony and the leaked Chinese reform details moved markets more. Even in the EU, the big story was ECB executive board member Peter Praet’s indication of more ECB stimulus coming.
The Eurogroup and ECOFIN meetings of November 14-5 hardly merited more than a few articles.
But make no mistake, these meetings were the real event to note this week.
Just as the Dubai World default in late November 2009 ultimately lit the fuse under what became the EU crisis, so too the events in Brussels may have done the same for the next, and perhaps final, chapter of the EU crisis.
Think I’m being overly dramatic? Let’s all pray that I am, otherwise most of us could be a lot poorer this time next year.
Ironically, this wasn’t even the week’s big headline event in the EU.
It Wasn’t Even The Main EU Headline Event
The big news from EU this week was the rising hopes for new forms of stimulus beyond the November 7th surprise rate cut. The ECB let markets know that a number of more exotic stimulus measures were now on the menu via comments in a November 13th Wall Street Journal interview from ECB executive board member Peter Praet.
Leading EU watcher Ambrose Evans-Pritchard recently wrote that this signaled nothing short of a coup within the ECB. Until now such talk was strictly verboten, on orders from the EU German and fellow hard money Northerner paymasters with the relatively healthy economies.
After years of recession, a weak recovery (ex-Germany) that is weakening, and now a rising threat of Japanese style deflationary spiral (see here for details), the “easy money” Latin majority in the ECB has risen up against the blocking minority, and raising the odds for an eventual US-style QE program in which the ECB buys sovereign bonds or other similar programs whose inflationary potential strikes a deep fear in German hearts.
However the mild drop in the EUR on that news showed that no one thinks such changes are coming soon.
That’s good, because the EU has enough controversy to face, because it has a bigger problem.
Unfortunately, this one has with a December 31 deadline, and the usual temporary solutions of lend and pretend may well no longer work, at least not for long.
Risking The Final Defense Against Another EU Crisis & Contagion Risk: Confidence
As we discussed last week here, we believe the biggest under-the-radar “phantom menace” for the global economy is the coming ECB bank stress tests. Unlike the EU bank stress tests of recent years, these will be serious tests, run by a now very serious ECB. It is motivated because it wants to uncover and recapitalize or close all failing banks before it assumes oversight responsibilities. In other words, it will work hard to avoid getting stuck with the cleanup bill, estimated at $50 bln (and these estimates tend to prove optimistic).
The danger lies in the bitter fight that will come over who pays and how. These are the hard some of the hard decisions that have been deferred for years (others involve choices between national sovereignty and the EU, but leave that aside for now).
Failure to actually finally resolve the issues unsolved for 4 years within the next 6 weeks, by year’s end, risks a loss of credibility the EU may not long survive, because the only thing preventing a possible financial collapse is nothing but sheer, unfounded confidence that:
- Sustains a willingness of investors to keep lending to insolvent sovereigns that can’t print their way out of short term trouble
- Prevents bank runs and a credit freeze on insolvent banks
In sum, the big danger here is that the usual solution for every EU crisis period, print money, then “lend, and extend” payback to those who can’t handle their current debt load, may not work.
Sure, it could be tried, there’s an excellent chance of that. Two big questions on that:
Will markets continue to act as though all is in order? Without clear progress to either a centrally controlled EU banking system (as well as a few other key ingredients of successful currency unions, like centralized budgeting that can transfer wealth from richer to poorer areas) how long will it be before that confidence breaks, capital flees, and suddenly there is no funding to roll over bonds coming due to buy more time for a solution?
Even if they do (hey, the EU has muddled through thus far), EU parliamentary elections in May mean that no deal by then means no deal for as much as 9 months per Sweden’s finance minister. Without a plan for dealing with banks that fail the stress tests, the whole centralization of bank supervision, a key component of any functioning currency union, goes on hold as well until some point later. Just hope no solvency issues arise in the meantime.
Obstacles To Year-End Deadline For Bank Recapitalization Plan
At last week’s Eurogroup ECOFIN meetings November 14-15, the EU’s 28 finance ministers struggled to agree on the details for the planned Single Resolution Mechanism (SRM) for recapitalizing or closing banks that fail the tests. It needs to be in place before the ECB can conduct its stress tests, which are due to start in early 2014. They’ve been hindered by
- Political paralysis of their German paymaster. Almost 2 months after German elections, Berlin has yet to form a new coalition
- Persistent divisions on the practical details regarding
- Who controls and funds it?
- Whether it should be backed by a central fund or whether each nation should fund its own banks
- Which banks should be covered by the final funding mechanism?
- Persistent divisions on the practical details regarding
The division runs along the familiar lines of
- the minority of funding nations seeking to avoid paying others’ bills via either direct contributions or printing the Euro and ultimately debasing the value of anything denominated in it, including the savings of funding nations’ voters.
- the majority of debtor nations seeking essentially as much of the opposite results as they can get, because are unable (due lack of money, political will, or both) to repay the combined bill for their own sovereign debts plus those of their undercapitalized banks.
Actually, It’s Not That Bad – It’s Worse
These obstacles don’t even include another huge one that needs to be faced at some point: revising the current polite fiction that all sovereign bonds on EU banks’ balance sheets are equally risk free and considered tier-1 level capital. The difference in yields and CDS spreads between various EU members, as well as the recent history of the GIIPS nations (perhaps ex-Ireland?) makes this unrealistic as the US’s chucking mark-to-market rules.
The difference between the US and EU is that the US is an integrated currency union with the means to keep its banking system stable for the foreseeable future, if for no reason than that the EU and Japan look worse (and the world can only focus on so many crises at a time).
The fate of at least some of the GIIPS nations, and their bonds, is far less certain. Meanwhile, their banks are full of these dubious assets. For example, Reuters recently reported that Italian banks cannot absorb much more of its government’s bonds.
The odds of making a deal before that December 31 deadline are dropping after they cut short talks in Brussels Friday.
Germany To EU: No Open Ended Risk Sharing
Some progress was made Saturday, when EU ministers overcame one of Germany’s key objections: the use of the common ESM fund to recapitalize failed banks. Germany wants each nation to be responsible for its own banks.
The EU finance ministers modified the wording of a statement on how they’ll deal with shortfalls after the European Central Bank’s asset-quality review and stress tests. The final wording recognizes the German parliament’s right to veto any direct aid from the region’s common bailout fund.
However Germany has not been able to agree to the new wording because it Angela Merkel’s Christian Union bloc and the Social Democrats (SPD) are still in negotiations to form Germany’s next government.
They remain at odds over the very issue of whether (and if so, how) to allow direct recapitalizations for weakened banks. There are key figures in the SPD who view use of any common fund to bail out specific banks to be as bad as Eurobonds, just another form of risk sharing which leave German taxpayers liable for others’ mistakes, corruption, mismanagement, bonuses, etc.
The EU statement’s revisions reflected its understanding of Germany’s reluctance to commit to rules before it forms a new government, its need to retain the right of German lawmakers to reject what may be unacceptable risks to Germany’s own finances.
The new wording was a brilliant bit of diplomacy:
- German politicians can still tell their voters they aren’t liable to pay for debtor nations’ failed banks
- The debtor nations can point out to their voters that when faced with paying up or the end of the EU, Germany has always written the check.
Again however, Germany has no government yet that can agree to that change in wording, nor is that issue the only remaining hurdle.
Of course, in keeping with recent EU (also US and Japanese) debt crisis handling tradition, the December 31 deadline could be extended, and many assume it will. However there are two big reasons why extend and pretend is especially risky, and may not work for more than a few months.
- First, there are EU parliamentary elections in May 2014. If there’s no agreement on funding the recapitalization or closure of failed banks by then, the elections could delay any agreement for as much as nine months, per Swedish Finance Minister Anders Borg.
- Second, and here’s the big problem, failure to reach an agreement would be a real blow to the EU’s credibility.
Without an in-place, credible funding mechanism to cover the estimated $50 bln (or more, let’s be honest) in asset write-downs that need to be replaced to sustain or close troubled banks without causing new contagion risks, the ECB can’t proceed with serious stress tests and the whole movement towards centralized bank supervision (the only hope for preventing another crisis and salvaging the EU’s credibility) grinds to a halt. If that happens, then the odds of survival for the EU as we know it become much worse.
How much worse? Hard to say, because the EZ currently survives on nothing more than confidence that it will make the reforms needed before the next crisis hits, or at least make enough progress to inspire enough confidence for some new lender to step in, or for currency markets to accept a lot of Euro printing without causing a crisis from an extreme plunge in the Euro. It’s impossible to say how long that confidence will hold.
Of course, in fairness to the EU, virtually all sovereign debt is sold only because buyers believe the debtor nation will be able to borrow enough when the bonds mature to repay the debt. Felix Salmon recently wrote a brilliant though disturbing perspective on the state of the most “risk free” sovereign bonds, see here.
Our guess: the EU once again resolves the issue by dodging the tough questions. Just as the language change left Germany a way out of funding bank bailouts that don’t suit its own interests, a lot of wiggle room will be left.
However in the past, such failures to ensure that the enough cash will be there in a crisis, have only raised uncertainty and further frightened markets, because these moves are seen for the tricks they are, and only undermine the EU’s credibility. Remember the summer of 2010 and the first attempts to calm the markets about the Greek contagion threat?
Let’s hope the EU gets lucky again. Here’s why
Just How Much Is at Stake: A Reminder
If the EU mishandles this it risks reminding everyone that not only is the EU crisis alive and well, it grown since we last saw it. Remember, the trick to keeping the EU crisis quiet is all about maintaining perceptions of stability. Greece and the GIIPS were a disaster waiting to happen long before the Dubai World default in late November 2009 got markets and the media asking where else were there any potential sovereign default risks. By May 2010 we had gone from EU leaders claiming there was no problem with Greece to a Greek bailout and more to follow.
If questions are again asked and the answers aren’t good enough, things could get ugly fast. Remember, nothing has been fixed since 2012’s promise of an OMT (never funded or implemented) calmed markets about Spain.
How ugly? I quote a recent article from Graham Summers:
“…we have several facts that we need to remember. They are:
- The European Banking system is over $46 trillion in size (nearly 3X total EU GDP).
- The European Central Bank’s (ECB) balance sheet is now nearly $4 trillion in size (larger than Germany’s economy and roughly 1/3 the size of the ENTIRE EU’s GDP). Aside from the inflationary and systemic risks this poses (the ECB is now leveraged at over 36 to 1).
- Over a quarter of the ECB’s balance sheet is PIIGS debt which the ECB will dump any and all losses from onto national Central Banks (read: Germany)
So we’re talking about a banking system that is nearly four times that of the US ($46 trillion vs. $12 trillion) with at least twice the amount of leverage (26 to 1 for the EU vs. 13 to 1 for the US), and a Central Bank that has stuffed its balance sheet with loads of garbage debts, giving it a leverage level of 36 to 1.
And all of this is occurring in a region of 17 different countries none of which have a great history of getting along… at a time when old political tensions are rapidly heating up.
To be clear, the Fed, indeed, Global Central Banks in general, have never had to deal with a problem the size of the coming EU’s Banking Crisis. There are already signs that bank runs are in progress in the PIIGS (Spain has lost 18% of deposits this year alone) and now spreading to France.
At that point, central banks obviously will have only two, maybe three choices, given that they don’t have anything close to enough spare cash lying around.
- Nations monetize everything, that is they raise the cash by selling bonds, most of which they buy themselves with ever increasing amounts of printed money, risking hyperinflation. If Europe opts for this route, it’s hard to see how Germany and its fellow inflation-phobic northern allies stay in the EZ. So that’s the end of the EZ as we know it.
- Allow selected sovereigns and banks to default, risking severe deflation.
- Expect a vast array of capital controls (price fixing, limits on capital transfer or withdrawal, etc.), with unknown effectiveness.
Really, this would be so big and has so many moving parts, many political, that it’s beyond anything we’ve experienced or could easily model.
Presumably all the decision makers know this and will make the hard decisions to avoid it. Let’s hope they do while they still can.
An Obvious Partial Solution To Minimize The Damage
Everyone would suffer, though some less than others. For example, currencies trade in pairs, so selloffs in some bring rallies in others, if for no other reason than that some are less bad than others. In currency markets, that’s enough to make a currency of even a highly flawed economy soar. It’s truly all relative.
It seems reasonable to assume, however, that those nations which are already deep into assorted forms of stimulus fueled by printed money now won’t hesitate to continue for as long as they believe they can get away with it without real risk of hyperinflation. Of course, they might not pull back in time to prevent that.
Therefore, consider learning how to identify the currencies more likely to avoid that fate, and allocating some of your portfolio into assets denominated in or linked to these currencies. To find out about the best guide I’ve seen to simpler safer ways to do that, within your risk tolerance and comfort zone, see here or here.
For more on lessons we learned for the coming week and beyond, likely coming week market movers and more, see here.
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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.