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The Euro-Zone: A dangerous mis-diagnosis

Michael Howell argues that austerity is the wrong solution for the euro-zone, and that bad debts need to be socialised or aggressively written-down to free-up seized credit markets

Allegedly, only three people have ever truly understood the euro situation: one’s dead; one’s mad and the third is in hiding.

Just over a year ago, with investor pessimism extreme and ECB boss Mario Draghi preparing a “whatever it takes” rescue, the risk-reward balance strongly favoured buying euro-zone equities. Today, buying more stocks makes less sense: investors are now so upbeat they try to forecast good news, while the ECB seems unsure how far Angela Merkel will allow it to go in further support and policy accommodation. German austerity battles Mediterranean privilege.

Europe’s economic problems are structural, the proposed solutions cyclical. At its heart, southern Europe’s industry is uncompetitive and it should never have been allowed into the euro at the parities the politicians engineered – not least because the costs of this error are now being shared by core and periphery alike.

But worse, perhaps, is the fact that European banking is fundamentally unsound. It is a bad business. Funding crises are inherent because of its fragile financial structure. There are three key issues that make Europe’s banking system look more like that of early-1990s Japan than America’s much cleaned-up banks:
• Bad loans have not yet been recognised, because capital cushions are too thin and look thinner still under Basel III. Post-recession loan losses typically total around 10%, but this time may be as high as 15-20%. Moreover, the tenor of EU policy is that neither governments nor banks will be bailed out and the private sector – look at Cyprus – will be explicitly ‘bailed-in’;
• Bank leverage (loans and investments to capital) is still around twice US ratios; and
• Deposit-to-loan ratios are down because, unlike in the Anglo-American economies and Asia, euro-zone banking relies unduly on wholesale markets, not ‘sticky’ retail deposits, for nearly half its funding. This is unlikely to change while Euribor interbank rates lie, at times, more than 150 basis points below the comparable government debt yields that compete for retail money.

Large, cash-rich euro-zone corporations finding new regional investment unprofitable and thwarted by high labour costs and regulation, dump funds into wholesale money markets. In theory, Europe’s banks should tap into this cash: they once did with alacrity, but today their weak credit ratings mean that this is expensive and often flighty money. This fact puts the cost of bank funding well above ECB reference rates, so paring lending margins.
Moreover, with most large, euro-zone corporations cash-rich, less interested in borrowing (and enjoying finer borrowing terms than the banks themselves, anyway), the hardest hit are the once dynamic, small and medium-sized corporations (SMEs) who traditionally rely heavily on bank finance and now either cannot get it or have to pay prohibitively high interest rates. The ECB cutting interest rates makes no difference to these SME interest costs and may even worsen credit supply insofar that the cuts emphasise how poor and risky the real economies really are.

In short, buying government bonds looks a better bet for the banks themselves. So, lending terms tighten, loan supply cuts off and, hence, euro-zone economic growth skids, in turn heightening the risk of greater loan write-offs. From Japan’s hard-bitten experience since 1990, European bank lending will not restart until these loan losses are realised. Note how the US Federal Reserve has lately led the way by buying up bad assets and encouraging US banks to take write-offs. Europe is at least five years behind.

Admittedly, many of Europe’s problems are shared elsewhere. But what makes the euro-zone different is, first, the scale of these problems, and, second, the region’s deep political divisions. Consequently, the ECB is in the business of crisis management.

Liquidity crises by their nature can spring up without warning, but fragile funding structures can quickly turn these into solvency crises and, hence, bank runs. Figure 1 shows our estimates of ECB liquidity injections into the euro-zone money markets. There is plainly no QE coming out of Frankfurt: the ECB’s balance sheet has shrunk by more than one-fifth in the past six months. If the US Federal Reserve reported similar figures, Wall Street would collapse.  

The next inevitable funding crisis will again spur the ECB into action, chequebooks in hand. The upcoming 2013 German elections may cause some pen-fumbling, but ultimately the money will come. The mysterious target-2 system that finances the euro-zone’s internal payments deficits is loaded against Germany and other creditors, such as Finland and Holland. The ECB simply writes an undated cheque to finance the periphery and then expects the Bundesbank to play ball by inflating German money to balance the books. Whoever thought this system up plainly forgot German history. Germany will never inflate, and to the extent that it feels so threatened it moves on to the offensive and tries to further squeeze out southern affluence.

Austerity plays well in northern European politics, but it is the solution for a short-term credit boom and not a secular debt crisis. Here, the objective should be to reduce the eye-watering debt-to-income ratios and not clip stagnant credit markets. Governments need either to take on and devalue the debts, or somehow get incomes growing again.
Even though the state sector is bloated, cutting incomes to do this will prove an uphill struggle. The euro-zone acts like the interwar Gold Standard. The burden of adjustment is lop-sided, falling largely on to the debtors, where retrenchments lead overall incomes into a downward spiral. In an eerie replay, France, then the most stubborn advocate of ‘hard money’, enjoyed the strongest currency in the mid-1930s, but was suffering the weakest by the late-1930s. Could the euro do the same?

In some places the debate is not whether the euro breaks up, but when. Being practical, however, the euro’s integrity is more secure than its value. Figure 2 shows the trade-weighted value of the euro, hypothetically extrapolated back to 1975.

Remarkably, the single currency looks more volatile than first impressions might suggest. It has not appreciated ever-upwards, but saw-toothed up and down. These shifts seem to correlate well with periods of economic convergence (Maastricht, single currency), which force the euro to appreciate, and periods of economic divergence (euro-communism, fall of the Berlin Wall, 2010 debt crisis), when its value skids.

Arguably, the chart trends suggest that the currency still may have another 20% to fall. Further fuelling this drop is Japan’s actions. There are few unrelated events in economics and the recent 25% drop in the value of the yen against the euro must already be hitting the pockets of German exporters. And, with the German economic machine spluttering, what hope Greece and Portugal?

Michael Howell is managing director at CrossBorder Capital

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