The euro-zone crisis: The more you struggle …
Remember Chinese finger traps? Those childhood toys that hold your fingertips ever more tightly the more you struggle to pull them free? Europe is full of them.
Deficits get bigger, thanks to growth-strangling austerity measures aimed at reducing deficits. Improving Europe's competitiveness will help to correct global imbalances but exacerbate intra-euro-zone imbalances. Thank goodness for the prospect of a weakening euro - surely that would boost growth without any nasty side effects?
Think again. Over the past 12 months, the net foreign exchange exposure of the euro-system has ballooned by €96.6bn to €277.4bn. The vast majority of that rise was due to US dollar swaps between the ECB and the US Federal Reserve.
During the dark days of 2008-09, the ECB wrote some big swaps with long tenors. But for most of 2010 and 2011, the euro-system only needed small amounts of dollars (tens of millions) for short amounts of time (seven days). Then US money market funds shut the door on Europe's commercial banks. From mid-October, the ECB once again entered into longer-dated swaps (84 days) for bigger dollar amounts (tens of billions). Since 8 December, it has swapped €64.81bn for $85.6bn - dollars due to be paid back between the beginning of March and the end of April.
Ordinarily, this FX exposure is spread through the euro-system - the banks receiving the dollars have to find them again when the swaps come due. But the banks need dollars from the ECB in such large quantities precisely because money markets think they are bust. So the credit exposure the ECB has to the euro-system is now compounded by a contingent FX exposure.
If the ECB had to buy $85.6bn at the time of writing, at the USD/EUR rate of 0.752, it would only need €64.37bn - leaving it €540m to the good. Its breakeven USD/EUR rate is 0.758. At the recent peak of 0.789, reached on 16 January, the ECB would have taken a €2.6bn hit. Until the end of 2012, the ECB's paid-up capital is a mere €6.36bn, an amount that would be wiped out by its USD/EUR exposure should the rate hit 0.833 - a rise of 10.8%.
Even if the commercial banks stay out of trouble, at what point in a slide by the euro would the Fed start to panic about its counterparty risk and call for more margin from the ECB? An early call for dollars from financial institutions would set asset-liability mismatches cascading through the euro-system and push USD/EUR even higher: the euro-zone could enter a full-scale balance-of-payments crisis, Asia 1997-style.
The gamble seems to have paid off: European bank CDS spreads are tightening, the European Banking Association has said there is no need for another stress test - and US money market funds have started lending to French banks for the first time in six months. But this balance-of-payments risk is another reminder, apart from intractable sovereign debt problems, of how fragile the euro-zone's financial system is - and of how releasing pressure in one place increases it somewhere else. As markets get caught up in a New Year recovery rally, it is worth bearing that in mind.
This story first appeared in the March issue of IPE magazine.