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Tuesday May 4, 2010 - 16:27:11 GMT
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It's Back...Sovereign Run, What Next? (FXA)

While the Euro Zone and ECB, along with the IMF, surely felt that the weekend EUR110bln bailout for Greece would at the very least buy some time for policymakers to begin implementing draconian fiscal adjustment, the time bought has turned out to be momentary…the run on Euro Zone sovereign credit (for Club Med) is back on and European banks are sinking in value across the continent.  Few think Greece has the stomach to swallow the poison pill of fiscal adjustment prescribed by the EU and IMF and even fewer think issuing debt to pay Greek debt is no way to run a monetary union.  If haircuts or default are not options for the European leadership, what other options do they have to arrest the run on sovereign debt in Spain and Portugal?


Well Spain and Portugal can step up and announce their own draconian measures to trim deficits (in case of Spain the debt problem is more private than public and especially severe in the state savings banks of Cajas).  But politics and a realization that deflation as a path to competitive adjustment in the midst of a deep recession is, to quote Spain’s Prime Minister Zapatero, shear madness.  And the deeper the cuts announced, as in the case of Greece, the less likely governments will be able to implement the measures. 


So it is not so surprising that more market participants are urging the ECB to do what the Fed did since 2008…use quantitative easing or buy EZ issued government debt from weakest sovereign credits from the banks…legally it can’t buy directly from the government issuers.  However, this would face huge institutional resistance inside the ECB and create a political Chernobyl inside Germany where a culture of anti-inflation runs from households to firms to government.  QE would be a step toward monetizing the debt of the weak EZ states (would not be monetization unless the ECB retained the expanded balance sheet permanently).  So this is way more difficult to engineer inside Europe and especially inside Germany than say the Fed deciding in 2008 to buy assets from the market (some Treasuries and mainly agency MBS – latter are implicit government securities). 


ECB meets Thursday and it will be interesting to see if any news emerges from the meeting to address market concerns over the credit worthiness of the Club Med debt (now better expressed in EURUSD).  Keep in mind this past weekend the ECB dropped its minimum collateral rule for taking Greek debt (at least one investment grade rating), something it denied it would do just weeks ago.  With the ECB closing down long-term refi operations (unlimited cash to banks at fixed 1.00% rate at up to one-year), we might see a similar reversal in policy…look at European bank stocks today…never confuse a quarter or two of bank profitability with a sound banking system…this one remains built on a mountain of toxic assets which have not been marked to market nor adequately reserved against.  Club Med debt and credit lines leave the European banks exposed to large new losses (no indication the banks are marking to market Greece, Spain or Portugal sovereign debt) and more importantly raise questions about capital levels.  It does not take a wild imagination to think the banking system in Europe and then everywhere could freeze up again if markets lose confidence in the European banks. 


If only Euro Zone officials could get past US prejudices, there might be a few important lessons learned from the US crisis.  Move early, move big and keep moving to at the very least stay abreast of the crisis if not staying ahead of the crisis.  And we have hindsight from the crisis that applies much more to the US experience than the EZ experience since the fall of 2008.  The Fed QE and liquidity operations proved that unlimited supplies of zero cost money has an amazing anesthetic capacity to paper over all sorts of structural cracks and resurrecting the system in place that led up to the crisis.   ECB should cut its refi rate to zero.  Embrace a weak EUR.  Announce QE.  And reopen long-term refi operations…all you want at zero.  Anyone worried about an inflation problem ahead should seek radical therapy.  ECB owes it to Europe and world growth…deflation is unacceptable and the overwhelming risk.


The world’s banking system would not survive a breakup of EMU and it would assure a return to the depths of the Great Recession in Q1 2009.   Unfortunately the actions to date by the ECB suggest it is not up to the task at a time when Euro Zone governments are out of answers.  What was a primarily fiscal problem is now primarily a monetary problem.    


David Gilmore     



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