Monday, March 10, 2008

Europe After the Rain

Please don't miss the Debt Rattle for March 10. It can be found here

It's time to walk again
It's time to make our way through
the fountained squares
And the collonades

Your dress is shimmering
Your voice is hiding things
When you say I've hardly changed
In Europe after the rain

Ilargi: I moved to North America many years ago, or so it seems. My passport, however, is still European, and I don't see that changing. I truly am a Son of Europe.

These days, I am worried about Europe. There seems to be very little awareness among Europeans of what is about to happen to them. So here's a little nudge: two articles, one by Ambrose Evans-Pritchard, a writer many profess to dislike, and a second by UBS many money man Meyrick Chapman.

This is presented as food for thought; just two articles, nothing conclusive, simply a starting point. I trust Europeans to make up their own mind. If they have the proper input, that is.

UBS warns euro will be pushed close to breaking point
Europe's monetary union may be tested to near breaking point as the economic downturn engulfs the bloc's southern tier, and German investors cut off a crucial source of foreign funding, according a hard-hitting report by the Swiss bank UBS.

"The coming two years are likely to prove the most testing time for the coherence of the single currency to date," said Meyrick Chapman, the bank's Europe strategist. "We expect that it will emerge unbroken. There is too much political and economic capital invested to break the project. However, adjustments are likely to be severe," he said.

UBS warned of a "funding freeze" for countries with very high current account deficits, such as Spain, Portugal, and Greece that have come to rely on in massive inflow of foreign money to plug the gap. Spain has built up the biggest cross-border liabilities with foreign debts of $362bn (£180bn), or 26pc of GDP. Italy has accumulated $275bn, Greece $129bn, Ireland $123bn, and Portugal $98bn.

Much of the funding has come from German banks and pension funds. They have shown a voracious appetite for cedula (covered bonds) and other forms of Spanish debt from 2005 to 2007. The yield was higher than stodgy offerings at home. The Germans have since brought down the guillotine.

"Following the market dislocation in July 2007, German buyers were almost entirely absent from the Spanish market," UBS said. The cut-off has left some Spanish borrowers starved of funds. Many have instead turned to the European Central Bank for temporary funding, using unsold mortgage as collateral for loans at the Frankfurt window. This is becoming a political issue. "It may raise awkward questions within the ECB Council," the bank added.

Under EU rules the funding is supposed to be "limited and temporary". Spain's banking association insists that the country's lenders are still in good health, with a solid capital base. The investor flight from the region has already become visible in the surging yield spread between German 10-year Bunds and equivalent Latin bloc bonds.

After remaining steady in the mid-20s for several years, the spreads began edge up last summer and finally exploded this week. They reached 70 basis points for bonds from Italy and Greece, two countries with towering public debts over 100pc of GDP. "It is certainly a wake-up call to be cautious about fiscal policy," said ECB's president, Jean-Claude Trichet.

A number of hedge funds and banks are betting on a further divergence, taking out "short" positions on Club Med debt with an offsetting "long" contract on Bunds. Goldman Sachs, BNP Paribas, and Deutsche Bank have all advised clients over recent months to take out such positions. The "liability" countries deemed most vulnerable to such attacks vary among themselves. Spain has a current account deficit near 10pc of GDP and a collapsing housing bubble, but is in good fiscal shape. Italy's trade deficit is manageable but the country is falling into recession.

What all the southern countries have in common is a relentless loss of competitiveness against Germany, year after year for a decade. UBS said it was unclear how Europe would deal with the likely crisis when it comes. EU rules forbid the ECB to provide liquidity to banks that are "potentially insolvent". An IMF study said the "larger countries will end up footing a disproportionately large share of the overall burden". The Germans will not like that.

Collateral Damage
By Meyrick Chapman

In some respects cross-border lending is the defining success story of the euro zone, and Germany has been the prime lender. At the moment, however, German money is staying at home. European Central Bank figures suggest a virtual halt in overall cross-border lending.

As a result of this and the closing of the securitization market, banks in some euro-zone countries, including Spain and possibly the Netherlands and Ireland, are facing a dearth of short-term liquidity and have become much more reliant on central bank funding. They may now be pushing the ECB's operational framework to the limit of what is acceptable. These countries may face painful adjustments down the road whose ripple effects would be felt throughout the currency zone.

Recent data indicate that this trend of ECB dependency began in August 2007 and was not just a "year end" effect, as some analysts have suggested. Over the past seven months, all national central banks in the euro zone have been providing significant extra liquidity to their local commercial banking system. All, that is, except the German Bundesbank. The reason for this single exception is probably due to changes to cross-border lending, and it may have long-term ramifications.

Throughout 2005, 2006 and early 2007, German investors were avid buyers of foreign asset-backed bonds, particularly from Spanish issuers and often as a substitute for their own lower-yielding German securities. According to Bundesbank data, between mid-2005 and September 2007 German banks increased their holdings of nondomestic euro-zone assets by €290 billion, including €107 billion in additional debt securities. The demand was so consistent that borrowers came to rely on German lenders.

But after the market dislocation in July 2007, German investors abruptly avoided non-German assets and turned solely to domestic securities. This homecoming seems to have afforded German banks funding opportunities just as these opportunities were shuttered elsewhere.

Banks that relied on securitization may now face funding constraints. These banks are primarily located in Spain, the Netherlands and Ireland due to the buoyance of mortgage lending in these countries in recent years. This funding gap intermittently has been filled by the ECB refinance facility, with "retained" asset-backed securities (mostly backed by residential mortgages) often provided as collateral. "Retained" issues mean the securitization process continues, but the assets stay on the bank's balance sheet, instead of being sold to investors. Banks have issued at least €53 billion in such securities since August 2007. Between July and November, Spanish savings banks alone raised their holdings of Spanish debt securities, most of which probably backed by residential mortgages, by a net €15.3 billion, according to the Bank of Spain.

In the first months of the credit crunch, the ECB rightly viewed its operational framework of accepting a wide range of lower quality securities, especially asset-backed securities, as eligible collateral as an advantage. It seemed to offer an effective liquidity buffer in difficult times. Certainly the operational record of the ECB looked good next to the disruptions in the U.S. Federal Reserve's open market operations and the Bank of England's unwelcome role as lender of last resort to Northern Rock, which could have been avoided if the U.K. bank had been able to present bonds backed by residential mortgages as collateral for funding.

ECB executive board member Gertrude Tumpel-Guggerell said in November that "as long as banks have sufficient eligible collateral for overnight or intraday credit, they have a buffer against liquidity shocks." But perhaps one can have too much of a good thing. She might have added: "as long as the ultimate liquidity provision does not become a permanent feature."

The ECB certainly demonstrates an aversion to providing permanent additional liquidity. Despite short-term spikes in provision, such as over the year's end, the ECB has been extremely careful to quickly return to a level of liquidity provision remarkably close to the average level of the last 18 months. So far the main difference appears to be that it now accepts more asset-backed securities as collateral. According to the ECB, by the the end of September these securities accounted for 17% of the €1.3 trillion in total euro-system collateral, up from 12% in 2006 and zero in 2003. Our own calculations suggest the holdings of asset-backed collateral may now be as high as 21%.

If the money-market pressures that existed in the final quarter of 2007 reappear, banks are likely to present more asset-backed securities as collateral to the ECB. It is not hard to imagine that the central bank may be concerned that its balance sheet could become overburdened with asset-backed securities whose value may deteriorate if there is an economic slowdown.

The ECB has an obligation to reflect the market value of the collateral presented to it. But with the market for securitized assets basically closed at the moment, the central bank is accepting assets that the private sector cannot value accurately. There is therefore a danger that the value given by the central bank does not fully reflect all risks, including the risk of default.

There are limits to the amount of risk the ECB will bear on behalf of commercial banks. How it resolves the problem will be tricky. What's more, by acting as the buyer of last resort for asset-backed securities, the ECB is delaying the necessary adjustment to the asset-backed market. A short-term palliative looks like it is turning into a long-term obstacle to the solution.

Perhaps such regional stresses are only a temporary feature. But if the Germans remain absent from the euro-zone credit markets for much longer, the credit crunch is likely to worsen in areas already exposed to potential overleverage and cooling economies. Spain and Ireland may spring to mind, but they are not the only countries, as German largesse has been pervasive across the euro zone. Germans' decision to stay at home may eventually threaten their own economy.

Mr. Chapman is euro-zone fixed income strategist at UBS.


Anonymous said...


thanks for these articles.

The imbalances within the Eurozone are getting worse every day.

Will the Eurozone break up?

Europe is a continent with very different cultures and very different economies.

Germany has always been a country with relatively huge export surpluses. These surpluses have been absorbed by Eurozone countries, but as well by the US, Russia, Arabian countries. Above all, monetary stability is extremely important to Germans.

France and Italy were and still are a bit different. Germany's gains in productivity used to be offset through inflation and currency debasements in France and especially Italy.

Neither Germany nor the Southern countries have changed. Germany is still becoming more and more competitive compared to countries such as Spain. At the same time, savers did not have very profitable investment opportunities in Germany. After all, Spain offered safe and higher yielding securities. And, the currency risk was gone.

Oh, wait! It's not gone of course. The trade imbalances are still there, only now the settlements have to happen in the real economy as well, not in the exchange rate.

So, Spain will, learning the hard way, have to increase productivity and / or lower wages and real income. Germany, at the same time, should raise real incomes and wages. The problem is, Germany's main competitors are Japan and China and the US, and Eastern European countries. Germany does not want to lose competitiveness to these countries.

The Germans who have invested into Spanish securities will pay as well - rising defaults will hit them hard. But, the core of Germany's economy are SMEs in machine building and other industries. It will be harder for them to get loans, too. The question is, just how hard.

Either, some Southern countries leave the Eurozone, or they adjust, both would be very hard for them.

And Germany? Someone has to absorb all the exports...

Stoneleigh said...

I am also European and I also see huge tensions forming in the Eurozone. IMO this does not bode well for European unity. When times are hard and there isn't enough to go around, old animosities resurface. I'm afraid that I think the future for Europe is balkanization, which is nothing short of tragic.

Ilargi said...


Germany has two large looming problems coming right up:
1/ there'll be no-one left to absorb their exports, the money simply won't be there to pay for them
2/ German financial institutions are heavily invested in the wrong paper

Anonymous said...


so far, Germany's exports are still growing, despite the very high Euro. Exports to non-Eurozone countries increased 11% in January.

But you are right, someone will have to absorb the exports. For the time being, Germany can still sell a lot of investment goods (machines, power plants) to BRIC countries.

The banks:
The public banks are indeed invested into worthless papers. The private banks are exposed as well, we may only have seen the tip of the iceberg. But I really doubt it is even remotely as bad as in the US and in the UK.

The very high Euro also means Europeans don't have to pay that much more for oil, gas and food.