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Monday May 10, 2010 - 19:45:36 GMT
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EU, ECB Buy Time, Not a Solution

There is no question that the scale of the EU-IMF budget emergency fund is enough to give former US Treasury Secretary Paulson a serious case of bazooka envy. 


But Paulson and Congress were firing their bazooka at a banking system with the support of zero cost of funds (thank you Ben), a steep yield curve and a Bush and then Obama policy of pushing the restart button for banks (reform later when new too bigger banks to fail are back on their feet) allowed banks to race back to profitability, write off plenty if not all toxic assets and recapitalize in a time that might see an arrow-shooting Usain Bolt celebrate. 


However, the near bottomless pit of potential aid on the table for the Club Med (and any comer) is not going into a rigged outcome like US banks enjoyed in the last 18 months.  Instead it should remind boat owners of a never ending black hole of expenses and an ever depreciating asset.  All the program achieves is the door of liquidity for the distressed sovereigns is open for a finite period if the need arises.  However, it does nothing to resolve the question of solvency, especially in the case of Greece.  Growth is the decisive factor too regarding solvent and insolvent credits.  Without it even countries with relatively better balances like Spain can get pushed toward insolvency relatively rapidly if the economy contracts for an extended period of time.  Naturally access to this pool of government liquidity comes with conditions, and a rate well above the Euro Area “risk free” rate.  Indeed austerity measures make restarting the local economy of Greece and Portugal more difficult.  And in the case of Greece it may well be past the tipping point of the debt death spiral…more austerity measures demanded for funding drives the economy deeper into recession and indebtedness.


Assuming Club Med growth is not in the cards for 2010 and 2011, then it all boils down to fiscal adjustment to turn this liquidity free pass (with a 1-2 year expiration) to get spending down and tax receipts up which for Greece seems a near impossibility.  Spain has a more private indebtedness problem than a public one like Greece’s and Portugal’s, so it should be able to soldier through, though not even Spain can carry on for long with a 20% unemployment rate and no growth which would drive private indebtedness higher and require ever greater public expenditures. 


And we don’t know what kind of approval process is needed to really free up these funds to the likes of Greece.  German Chancellor Merkel is smarting from a thumping in the NRW election which saw her coalition lose its majority in the upper house.  Returning to the parliament for approval for a much bigger bailout facility after the NRW result seems sketchy at best.  Merkel said only that she would see her cabinet approval (the structure of the aid is being offered through an emergency facility provided in the Maastricht Treaty which may negate the need for government approval…assuming legal challenges fail). 


Also the allocation of the funds has not been established – IMF to run it initially but one would think that a European Monetary Fund may be in the cards.  And there is some speculation that the European Commission will use this crisis to begin issuing bonds which would help shift focus from the part to the whole of the EU/EZ.  But this would have to come with central authority over local debt issuance which itself suggests a significant surrender of autonomy and surely that is not politically feasible. 


Looking at the ECB part of the bailout, one is struck by the flexibility of the central bank…indeed so flexible that Trichet’s 180 degree shift from last Thursday, to me anyway, raises issues over his credulity.  Watching the EUR trade in response to news of the ECB’s role in the bailout it was interesting - to see the EUR first sell off on news of planned purchases of EZ government bonds by the ECB only to reverse when the ECB finally issued its own statement indicating it would sterilize the bond purchases and thereby not engage in quantitative easing or debt monetization (unabridged endorsement of inflation).   Show me the journal article on monetary economics that establishes when credit easing ends and quantitative easing starts.  The Fed is still asserting that its massive expansion of its balance sheet is not quantitative easing as it plans to sterilize it (sell back assets bought and use other tools to take liquidity out of the banking system on a longer-term basis).  I would not get too caught up in the debate of CE vs QE or the suggestion that somehow the former is less destructive for a currency (all else being equal) than the latter.  How destructive this turns out to be for the EUR should depend on how much debt the ECB buys, and not what it is called.  If the ECB sterilizes bond purchases immediately then it has a legitimate claim to downplay the inflationary consequences of the policy tool.  But even under this circumstance, the ECB has gone political no matter the timetable and size of debt purchases and this had to be hard for Trichet and everyone else on the ECB governing council last night.  Moreover, any central banker knows the problem the Fed faces in unwinding its own asset purchase program (see the Milken Institute panel discussion with WSJ’s Hilsenrath, AEI’s Reinhardt and a few others – link in my Alert email last week…hat tip to Aitken’s NFSI for this key discussion).


So here is what I really think on the euro….the ECB has gone off the reservation of price stability and independence.  And with the CDS and European bank stocks relieved from trench warfare for the time being, the focus should shift to the EUR…a confluence of selling that was previously split among Euro Zone bank stocks, sovereign CDS and credit/bond spreads may now get channeled into the euro.  If I am right about this (EURUSD is back to where it traded at the open of Asia trading earlier today when markets first reacted to the news) the EUR is about to come under ever greater selling pressure.  And this begs the question of what next?  Keep in mind that weak links in the EZ chain benefit from a lower euro and there is scope for imported inflation in light of the very wide output gap and the desire to avert deflation (unstated but implied by ECB actions).  I have to think that behind the scenes there are active discussions about a euro rescue plan, just in case I am right about the channeling of negative EZ sentiment (fiscal and monetary in nature) into the EUR…coordinated intervention from G20 – aimed at introducing two-way risk…c bankese for smoothing declines and not necessarily reversing the move.


If the ECB and Europe, or the rest of G20, decide that currency intervention is not its cup of tea, then plan C looks like a form of capital controls sold under the auspices of a smack down on speculators.  Legislating away hedge funds, leveraged trading and the CDS market is no way to hide what is wrong with the EZ.   Ironically, legislating away the CDS market will increase selling pressure on the EUR in times of stress over EZ fundamentals…one less hedging roadway for investors and speculators to take.  And if some are right, and I have no reason to doubt them, the EZ learned quite recently that the selling of Club Med bonds was not simply speculative in nature…German pension funds and insurance firms were running from this risk en masse.  And it is very clear that the banks themselves with exposure to Club Med bonds played a key role in the move up in sovereign CDS as they hedged risk. 


I have thought through the move down in EURUSD that started around the end of 2009 has been orderly with the exception of last Thursday.  And the euro is still above its long-run average of something in the 1.18-1.20 area versus the dollar.  Moreover the late 2000 low was ..8225…miles away.   Yes even with coordinated intervention ahead, because CDS, bank stocks and bond spreads are temporarily underwritten by the EU and IMF, the EUR is now the only way to express a bearish view on the Euro Zone -  all roads now lead to the euro autobahn with only central banks trying to impose a speed limit.


David Gilmore




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