Friday’s announcement that the European
leaders of the Eurozone agreed to use the European Stability Mechanism (ESM) to
recapitalise Spanish, Italian and other banks was met with euphoria.
Under the preliminary agreement, the ESM
will be able to use part of its EUR 500 billion credit reserves to participate
in bank recapitalisation, subject to certain conditions which include the
development of a pan-European banking regulator under the European Central Bank
(ECB) as well as a wider national commitment to an austerity / balanced budget
programme.
Several commentators have already remarked
that the agreement lacks detail. I will go a step further and argue that the
dual mechanism of European banking regulation plus bank recapitalisation will
fail to prevent future situation equivalent to that where Spanish banks need recapitalisation. While the recapitalisation may take place and provide momentary relief for the "zombie banking system", the root causes of the problem remain, while regulatory compliance will prove impossible to implement.
The reasons for this are based in two
salient facts: recent history, and regulatory operations. If we look at the
emerging market debt crisis of 1982; the US savings and loan crisis of 1987;
the east Asian currency crisis of 1997-1998; the dot.com boom and bust of
1999-2000; the mortgage/property crash of 2007-2008; and the sovereign debt
crash of 2009 and onwards, we readily see that these crises were caused by an
excess of capital chasing outsized returns from a relatively few real
investment opportunities.
This search for outsized returns is
possible either at the early stage of the boom, or by taking on massive
leverage, or by finding gullible investors, or by illegal activity. Or a
combination. But the longer a boom continues, the more difficult it becomes to
regularly earn high returns. Market saturation results; the good opportunities
are taken; competition lowers margins for everyone. As a result, bubbles burst.
In each of the cases mentioned, the initial
investments and subsequent credit or investment booms were entirely legal.
There was nothing inherently illegal, for instance, about dot.com stocks being
valued at 200 times earnings. Similarly, there was nothing illegal about
adjustable rate mortgages, or sovereign loans to Greece.
The problems occurred when too many
institutions starting throwing too much money at too few opportunities. This is
a common factor in most boom-bust cycles, but it has usually has little to do
with regulation.
This is not to say there were regulatory
failings: there were many, and these have been widely documented after each
crash.
But during the boom, a common
factor is that the power to regulate loses its political acceptability in
inverse proportion to the outsized profits being made.
Let’s look at the Spanish bank
recapitalisation as a case study. Spanish banks are currently in dire need of
recapitalisation primarily because the Spanish property market boomed in the
1990s through to about 2005. This investment boom was very well known and
widely reported. See The
Economist’s survey of Spain in June 2004 as an example:
The first problems for
the new government are the demand for housing, which is such a large component
of general economic growth, and the supply of labour, which also drives growth,
though by boosting jobs, not productivity. Spain made a start on 700,000 houses
last year, four times as many as Britain. Even so, prices for new Spanish
houses rose 18.5% and for existing ones 16.7%. The boom continues, fuelled
partly by foreigners drawn to Spain by the thought of a house in a sunny part
of the euro area, partly by share-shy Spaniards looking for an investment. The
upshot is that though 3m-4m houses stand empty and a similar number are used as
secondary residences, many young Spaniards cannot afford even the smallest
flat, and thousands of workers turn down job offers that involve moving house
because they cannot find a house to move to. At the same time household
indebtedness has risen sharply (nearly half of the average family's disposable
income goes on servicing housing debt), while some 40% of Spanish capital stock
is in nothing more productive than property.
This single paragraph summarises everything
wrong with the Spanish economy at the time.
Remember that in
the mid-1990s, the whole objective of economic development in Spain under
standard EU procedures was to attract domestic and foreign investment and promote
economic growth. One of the main beneficiaries of the Spanish property boom was
British and German vacationers, and speculators. Some of the main sources of
capital for property development in Spain came from British and German banks.
The problem was—and
remains—that nothing about the Spanish real estate boom was illegal, or even
unsustainable, unless financers, customers and regulators were to have taken a
much longer-term, conservative view.
So let’s assume
the impossible: that a long-term, “economically rational” or conservative view
prevailed among public policy makers, bankers, developers and customers. What
could have regulators done to stem the property rush? There are several classic
policies, ranging from requiring a greater deposit ratio for mortgages, to
increasing a transaction tax on frequent sales of homes in order to avoid “flipping”
or other speculation.
All these tools
exist. But experience shows us that applying them is nearly impossible.
Now let’s
fast-forward to the ESM and the ECB. Thus far, the European Central Bank has
been placed in a nearly-impossible task of maintaining a Euro-wide inflation
target while providing liquidity to European banks. Along the way, it has
purchased over EUR 200 bln in sovereign debt, which it is not supposed to do, and
also lent over EUR 1 trillion to European banks under LTRO, not counting
additional loans previous to LTRO.
What exactly is
this ECB bank regulator supposed to do in the next boom? Order Spanish banks to
stop lending for property development? Insist via the Eurozone economic
planning committee that Spanish property taxes should rise by 10% to discourage
speculation? Force Spanish banks to increase the deposit ratios to 40% of
mortgage loans?
Does anyone
realistically see this happening?
Most Eurozone countries, including Germany,
have been in breach of the Maastricht criteria since their inception. These
criteria underpin the European convergence criteria, and therefore the basis of
European monetary policy. Let’s remember what these criteria are:
1. Inflation no higher than 1.5%
of the average three best performing member states in the EU
2. Annual government deficit not
more than 3% of GDP
3. Government debt not more than
60% of GDP
4. Long-term interest rates not
more than 2% higher than the rates of the three lowest-inflation member
states.
These criteria are the real problem in the
Eurozone crisis. They impose an inflexible, rigid set of macroeconomic and
fiscal standards which are almost impossible to apply in a monetary community
of 17 member states, which pack small, service centres such as Ireland, Cyprus
and Malta alongside larger economic powers such as Germany or France. They are
also impossible to enforce given the lack of a single, elected budgetary and
decision-making authority (which is ironically what Germany is trying to
develop).
These criteria themselves have fed the
economic boom-bust cycle. As countries with weaker government economic planning
and weaker enterprises such as Spain, Italy or Greece entered the Eurozone,
they saw interest rates fall, leading to a massive credit expansion in both the
public and private sectors. This credit expansion was fuelled by lower interest
rates, and by the fact that credit was secured not only by normal economic
conditions, but by the very convergence policies and infrastructure spending
channelled through the European Union (Common Agricultural Policy, Structural
Funds, etc.).
The results today are clear: there has been
a massive transfer of credit and investment from better-developed capital
markets in northern Europe (and Asia and North America) into the southern
European countries. This was used for everything from capital investments (hospitals,
highways, ports, schools) to private homes to luxury consumption (imports of
Porsche Cayennes and Hugo Boss suits).
Eventually, the boom turned into a bust,
either in terms of the state-led development model (Greece) or the property /
tourism boom (Spain). Now creditors and lenders are left with non-performing
loans and deteriorating public and private assets that are rapidly losing their
value.
The classic solution in this case is a debt
restructuring and work-out. It is not a EUR 100 billion recapitalisation in
exchange for “better regulation”, which will be politically impossible to
implement.
The sooner Greece, Spain and other
countries (including the UK and Germany) come to terms with re-pricing asset
values and their associated debt service assumption, and restructure these
loans contracts, the sooner the crisis will end and “normal” growth will
resume. Until the next bubble, of course.
© Philip Ammerman, 2012
Philip Ammerman is Managing Partner of Navigator Consulting Group and European Consulting Network. He works in the field of investment management and due diligence in Europe, the former Soviet Union, and the Middle East.
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