In the fall of 2011, several analysts, myself included, suggested that a commitment of EUR 2 trillion in public and private sector funding would be necessary to secure the refinancing of sovereign debt obligations in 2012, together with refinancing of certain private sector loans. (See related posts at bottom of page).
In a subsequent post, Towarda Grand Deal on Bank Refinancing and Sovereign Loans, (December 2, 2011) I outlined the structure of the apparent solution, which I repeat below in italics:
The scale of the problem is therefore clear: governments must refinance a large amount of bonds maturing in 2012 (these numbers do not include the United States, the United Kingdom, or other indebted countries such as Turkey). Banks are reluctant to refinance, or unable to given the Greek PSI and increased capital requirements.
A grand deal would seek to solve these two factors in parallel, using the following steps:
1. Extending ECB lending as well as maturity terms to banks. This would require quantitative easing for the private sector by the ECB, and also extending maturities from 1 year to possibly 5 years.
2. As part of such an agreement, banks agree to repurchase a certain share of Eurozone sovereign debt, most likely in the range of 60-65% of total outstanding debt.
3. The IMF steps in with a formal austerity programme for Italy and Spain, enabling them to refinance part of their needs using ECB-IMF resources. It is likely that IMF-ECB resources of at least EUR 200-250 billion will be needed.
4. The ECB is given limited authority to continue secondary market sovereign bond repurchases, perhaps by another EUR 100-150 billion.
5. The banks agree to participate in the European Financial Stability Facility (EFSF) capital increase, perhaps to EUR 800 billion. This add about EUR 400 billion to the fund, which is then used to repurchase sovereign bonds as well as possibly bank refinancing.
6. The Eurozone adopts much stricter rules on the public finances of its member states. It is not impossible that a "new Eurozone" emerges.
7. The European Banking Association (EBA) delays its core capital increase, or alternatively allows an exemption for central bank guarantees or ECB credit lines. It is difficult to see exactly how this would work, but some solution will no doubt be found.
It’s interesting to see how this has worked in practise:
a. The ECB proceeded with a Long Term Refinancing Operation (LTRO) for the private sector, extending over EUR 1 trillion in low-interest 3-year loans, with January and February 2012 (see The Mother of all Carry Trades, January 14, 2012). The banks have in turn used this liquidity to participate in sovereign bond auctions: French and Italian yields have fallen. Points 1 and 2 of my forecast were accurate.
b. The IMF has not, so far, stepped in with additional refinancing for Spain and Italy. They have been able to refinance through normal channels, eliminating the need for an IMF programme. Point 3 of my forecast has not materialised.
c. The ECB has continued its secondary sovereign bond purchases, intervening particularly heavily in the Italian market in December 2011. As predicted, however, it has had to stop given political opposition to sovereign bond buying, and due to LTRO. Point 4 is confirmed.
d. The EFSF capital increase is occurring, although it is being split with the parallel and simultaneous expansion of the ESM. Germany has now indicated that it is not opposed to a capital increase, providing that other Eurozone countries follow suit, and has also signalled that the EFSF and ESM may operate in parallel, with resources likely to exceed EUR 800 billion. Point 5 is confirmed.
e. Stricter financial conditions on Eurozone public finance were agreed this past Friday in Brussels. Several countries have adopted a constitutional “debt brake” as suggested by Germany. Greater coordination and enhanced penalties are now in force. Point 6 is confirmed.
f. The European Banking Authority (EBA) has not backed down on its proposal to raise core tier 1 capital levels. This is leading to continued problems in bank operations, although LTRO has provided a temporary easing. Point 7 of the forecast has not materialised.
So 5 of 7 predictions made in my post of December 2011 were realised by the early March 2012.
If we take the liquidity and loan interventions made since September 2011, we see that the EUR 2 trillion limit has indeed nearly been reached, at least in theory:
· EUR 1,018 billion in LTRO phase I and II by the ECB
· EUR 70-80 billion ECB secondary market bond purchases in the fall of 2011
· EUR 780 billion EFSF financing (which corresponds to EUR 440 bln lending) in mid-2011 (capital has not yet fully raised, but recent auctions have been successful)
· EUR 700 billion ESM expansion (neither operational nor funded), and also not taking into account funding already committed to EFSF.
There are, however, several main problems with this “optimistic” scenario:
a. Neither the EFSF nor ESM are fully funded: the ESM is not even operational.
b. The LTRO has been granted by the ECB to banks, with the quid pro quo that banks would purchase sovereign debt. So far, this has materialised, but given the amount of bank deposits at the ECB, it’s clear that fears have not yet receded. It’s therefore an open question whether a future financial crisis can be adequately addressed by these two mechanisms.
The third problem is that already mentioned in my earlier posts: the ECB has expanded its liabilities by over EUR 1 trillion with LTRO and over EUR 120 billion with sovereign debt purchases. There has been no commensurate expansion of its own assets. Absent a capital increase, we can expect two potential impacts in the future:
a. A euro devaluation, or
b. The exacerbation of yet another financial crisis due to doubt on ECB solvency.
What is striking to any objective observer is just how difficult it is for the Eurozone to agree upon and implement what amounts to a standard fiscal policy during a time of crisis. Any number of analysts and commentators have been warning that more firepower is needed. Instead, we have seen funding commitments but no actual funds (EFSF, ESM); LTRO rather than straightforward Central Bank quantitative easing; continual reassurances (particularly from Germany) that no more is needed—until the next crisis sweeps away Europe’s defences.
The fate of the European economy now rests in the hands of approximately 25 banks and whether they will be willing to buy higher-interest French, Italian and Spanish debt in 2012 with low-interest loans they have taken from the European Central Bank.
It’s a really strange way to run a railroad. But great business if you can get it.
October 9, 2011
September 23, 2011
September 20, 2011
© Philip Ammerman, 2011