Politicians Trying to Sell PIIGS in a Poke

The fourteenth emergency European summit provided another trillion €uro package and to the extent that any agreement was reached, it was better than the unlucky 13th summit last weekend. The agreement is long on rhetoric and short on details but can be divided into four categories all of which are inadequate. There will be an inadequate bank recapitalisation plan of €106bn. There will be an inadequate Greek haircut of 50% of GDP. There will be additional but inadequate fiscal austerity from Spain and Italy. There will be an inadequate leveraging of the European Financial Stability Fund through a combination of credit enhancements and insurance leverage through a Special Purpose Investment Vehicle.

The aptly named SPIV spells the true nature of this policy; it is a massive confidence trick. Europe’s politicians are trying to sell PIIGS in a poke. We do not believe that private investors will fall for this confidence trick and private capital will continue to retreat from the peripheral economies.

The agreement represents a pyrrhic victory for Germany and the ECB. Germany was unwilling to fund the periphery without a substantial degree of economic control over the fiscal policies of its southern neighbours and has insisted that European treaties need to be changed. These treaty changes are fraught with political pitfalls and will require referendums in Germany, France, Holland, Finland and the UK.

The fourteenth emergency summit has kicked the can down the street and there will be a 15th meeting next month to flesh out the details of the package, but we have no doubt that emergency summits 16 through 21 will take place through the first half of 2012.

2012 will be a year of recession in Europe. We expect European GDP to contract by 0.5%. Fiscal austerity and bank deleveraging means recessions are inevitable in the peripheral economies. However, the most important recession will take place in France. We expect French GDP to contract by 0.3% next year. The rapid deterioration in business and consumer sentiment over the past few months as well as the rise in unemployment and contraction in lending standards emphasise the downside risks for the economy.

Recession will rob France of its triple AAA sovereign credit rating. This will undermine valuations of the EFSF and its accompanying SPIV, raising the costs of funding in Europe and emphasising that the true triple AAA European economies are restricted to three members inside the €urozone; Germany, Holland and Finland and three members outside the €urozone; UK, Sweden and Norway.

The €urozone Con trick highlights excessive debt within the region. This debt is stifling growth, which in turn means that the affected countries cannot grow their way out of the current crisis and this debt will eventually have to be written off. This will take place through a series of sovereign haircuts. The next in line at the barbers is Portugal, but we expect it to be followed by Spain, Greece again, Italy, Ireland and Belgium over the next few years.

The Con trick also emphasises the shortage of safe haven bonds in the world of excess savings and increasingly repressive financial regulation, we recommend that investors remain overweight the bonds of these safe haven governments.

After the inconclusive thirteenth emergency summit at the weekend, politicians moved on to a hopefully luckier 14th emergency summit yesterday. There were four main points of agreement, although short on detail and with a long tail of implementation issues. These involve agreement over a “voluntary” 50% PSI haircut for Greece (although the ECB is being spared the ignominy of being defaulted upon), a €106bn bank recapitalisation scheme based on mark-to-market sovereign prices at the end of the September and giving the 70 systematically important banks reviewed until 30th June 2012 to raise their core tier one capital ratios to 9% or face forced recaps from national governments (and if they are unable to provide the funds, this will be provided by the ESFS). These bank recaps have been augmented by bank funding guarantees, which are once again short on details and delegated to the national level. In addition, the “leaders” agree to leverage the European Financial Stability Fund to €1tr, but again failed to provide precise details on how this would be achieved.

Finally, Spain and Italy have agreed to further austerity and privatisation programs, but these are largely a rehash of previous promises rather than any new measures and particularly for Italy carry substantial execution risks. This is not a final solution and it only reaches the barest minimum of what could reasonably have been expected because of the total inadequacy of the previous thirteen summits. Another summit next month will flesh out the details, but emergency summits 16 through to 21 are expected to take place during the first half of 2012 as global investors once again question Europe’s ability to pull off the biggest confidence trick in history. It even describes this as a confidence trick on the can with the insurance scheme now being named a Special Purpose Investment Vehicle, SPIV, and who says the Brussels bureaucrats have no sense of humour!!!!

The English language idiom “Pig in a Poke” refers to the confidence trick perpetuated in the Middle Ages, when meat was scarce of selling cat or dog in a sack and pretending that this was a pig. The phrase refers to something that is bought of sold without the buyer knowing its true nature or value, especially when buying without inspecting the item prior to the transaction. European leaders are attempting a similar trick by trying to sell PIIGS in a poke. The justification is the lack of meat or in modern parlance, money from Germany and other triple AAA rated countries to fund transfers to peripheral economies to help cope with the fiscal austerity and deflationary bias required to restore competitiveness. The expression is also the origins of another familiar phrase, “to let the cat out of the bag” ie to reveal what is in the sack and express the truth. Mervyn King has fulfilled this role by noting that the current discussions can kick the can down the road for one to two years but they do not constitute a lasting initiative. We believe that the time span to the next crisis will be considerably shorter than one to two years. Indeed, the next round of crisis meetings is likely to take place within the next six months.

Germany has rejected the most obvious solution to the European crisis, a full transfer union in which the rich economies fund the weak, uncompetitive peripheral economies on the grounds that this would represent taxation of its electorate without representation (having a say in what these countries do with the funds). Germany knows that it will eventually have to fund the periphery if the single currency is to have any hope of success and will also reopen Pandora’s Box of treaty changes in an attempt to gain European acceptance of a Finance Ministry based in Berlin that overseas national budget and has the power to intervene to withdraw sovereignty from recalcitrant states. This legislation will have a difficult passed through national parliaments let alone referendums in the Netherlands, Ireland, UK and Finland. In light of the recent German Constitutional Court ruling on the first Greek bailout where the Court drew a line in sand over further transfer of sovereignty, Angela Merkel may also be compelled to hold a referendum in Germany.

A fiscal transfer union cannot proceed without greater political union. Our views are coloured by the fact that that the single currency is a political rather than an economic project and we believe in the sanctity of economics. As a political project, it is likely to suffer the curse of Enoch Powell who noted that: “all political lives, unless they are cut off in midstream at happy juncture, end in failure”. There is too much political capital involved in failure at the current juncture, but we believe that the process from ERM to the single currency and then onto political union has been designed to remove currency volatility and then interest rate volatility, but ultimately it will end in political volatility.

The second best alternative to German-funded political union has been for the ECB to leverage up and purchase unlimited amounts of peripheral debt. It doesn’t take Sherlock Holmes to realise that this was anathema to Germany and Merkel was quick to rule out this possibility and is refusing a permanent support role for the ECB’s Security Markets Program. Never say never, German objections to this QE(U) are unlikely to persist through 2012 as it becomes clear that Europe faces a choice between monetising Europe’s debt and the collapse of the single currency, but this is a last resort for Germany and will have lasting consequences for politicians. We do not believe that monetising debt would be inflationary given the massive and prolonged deleveraging of the European banking system that will have to take place over the remainder of the decade.

In the absence of German money and leverage, the alternative must be a combination of default and insurance. Politicians, even Nicholas Sarkozy, have accepted the need for a substantial Greek default but the ECB’s refusal to accept haircuts just underlines the central bank’s belief that the credit risk inherent in peripheral government bonds should be a fiscal rather than a monetary issue and responsibility should lie with the European Financial Stability Fund, which has been set up with member guarantees to cope with these fiscal issues. This belief is underlined by German objections to allowing the EFSF to continue secondary market purchases. Unfortunately, the newly increased size of €440bn is insufficient to deal with the liquidity and solvency crises within the periphery.

There are two options to increase leverage through the insurance route. The first option has been euphemistically titled credit enhancement approach and consists of the EFSF providing collateral for peripheral governments, Spain and Italy, to improve demand and pricing for primary issuance. The second strategy is to set up an SPV structured to provide European and non-European participation that in turn would provide first loss insurance for purchases of primary and secondary peripheral debt. The initial design of this plan was for the IMF to provide funding, but this would have required a substantial increase in IMF resources. Emerging economies would have preferred this option, but wanted increased voting rights in return for their support, while both the UK and US were unwilling to support a substantial increase in their commitment or surrender voting rights. Subscriptions to this new SPIV are likely to be gathered at the G20 meeting in Cannes on November 3rd/4th. The SPIV can then be structured to achieve leverage as a CDO squared and undoubtedly the Brussels Baldricks can produce a cunning plan that provides this structure with a triple AAA rating, As the table of S&P ratings between 2000 and 2008 show it is relatively easy to produce a triple AAA rated structure, although contrite rating agencies now qualify these structured finance triple AAA’s with a SF moniker (the modern equivalent of easy A(AA)). The size of this SPIV and the resulting leverage will not be determined until the end of November, providing yet another example of European politicians’ ability to perennially underwhelm investors’ expectations.

This is the PIIGS in a poke that €urozone politicians are trying to sell. The credit enhancements that the EFSF is offering to support primary issuance will be backed by EFSF bonds, which in turn are partially guaranteed by Italy, Spain and France; each of whom are likely to be downgraded over the next twelve months as their economies slip into recession. Likewise, the select band of brothers who become SPIVs do not know in advance their fellow members or the conditions under which this CDO squared will operate. Brazil has rejected the notion of participation in this shell game but China has given positive noises, but any contribution is likely to be modest and the Merchants of Beijing will undoubtedly extract their pount of flesh in return for providing some vendor finance to this risky venture. Spain and Italy will probably be asked to provide a memorandum of understanding, which with or without Silvio Berlusconi in power will not be worth the paper it is written on. As Harold MacMillan said in response to the question of what is most likely to blow government policy off course; “events, dear boy, events”, SPIV(y) investors have no control over the economic policies and economic activity of the peripheral economies. Reports of Berlusconi’s political death may be premature and he could hang on until the spring, but hopes that he will be replaced by an interim technocrat government that will miraculously pass all of the unpleasant legislation. There is a great deal of goodwill towards the €uro within Italy, but there is equally considerable resistance to the policy necessary to maintain this “hallowed” status. Moreover, there is little guarantee that the resulting elections will provide a conclusive mandate to follow the technocrats. Elections take place in Spain even sooner, on November 20th and the leading conservative party Popular Party does have a mandate for fiscal austerity and reform, but this mandate is unlikely to last the forthcoming events.

The next major event that the politicians will determine over the next couple of weeks will be the scale of the Greek default. We believe that Germany will succeed in forcing through a 50-60% haircut. It is very unlikely that the necessary 90% of investors will voluntarily accept this NPV loss, and this will constitute a credit event triggering the sovereign CDS clauses. EU politicians appear determined to prevent a credit event and are desperately trying to word the agreements, but if CDS no longer provides an effective hedge against the peripheral sovereign debt crisis, then an increasing number of institutional mandates are likely to be reconstituted to exclude these peripheral government bonds, which will reduce private sector demand and deepen the crisis. This is the classic law of unintended outcomes. The Greek haircut is designed to reduce Greece’s prospective debt to GDP ratio down to 120%. This is still too much and with Greek elections a virtual certainty next year we believe that the prospective government will renegotiate the terms of the austerity and we will require another debt devaluation of a further 50% within the next three years.

The Portuguese Prime Minister has made it clear that in the event of a substantial Greek default, his country will also require a second bailout. The first package provides funding through until 2013 so there is no immediate requirement for an additional bailout, but we believe that by the second quarter it will be necessary to provide another package. Although suggestions that the European Stability Mechanism would be brought forward from July 2013 to July 2012 have proved to be false, we believe that German will demand private sector involvement as a condition for agreeing to a second Portuguese bailout. The Portuguese economy is expected to contract by 2.3% during 2011. The deficit for the first half of this year was equivalent to 8.4% of GDP, down from a revised rate of 9.8% in 2010, but substantially higher than the target agreed last spring of 5.8%. We believe that it will be even more difficult to reduce the deficit further during 2012 when we expect the economy to contract by 3.3%.

A Portuguese haircut will add to the problems of the Spanish banking system and bailout costs. The forthcoming stress test where peripheral government bond positions are marked to market and banks required to hold a core tier one rate of 9% are expected to require recapitalisation of €100-110bn. This is the lowest possible credible number. Banks will be given six to nine months to raise this capital and if they are unable to do so, national governments will be required to provide the capital and if this is not possible, governments will be able to borrow from the EFSF. We assume that both Spain and Italy will require funding from via this route, which in turn will result in further credit downgrades. More importantly, we believe that Europe’s banks will have further substantial sovereign credit write-offs over the next few years as we experience a series of controlled defaults (debt devaluations) across the periphery. We believe that Spain will be amongst this group with a required haircut of at least 25% of GDP.

Spain faces an additional problem of a double dip recession over the next twelve months. The purchasing managers’ indices for manufacturing and service sectors declined to 43.7 and 44.8 respectively increased by 95K during September, whilst unemployment increased by 95,800 during the month. Retail sales fell by 4.4% during the year to August, while housing permits and transactions fell by 12.7% and 38% respectively in the year to August. We expect Spanish GDP to contract by 1.2% during 2012 preventing further contraction in the budget deficit. The deficit is expected to widen to 8.1% in 2011 above the government’s target of 5.8%. Indeed, we expect the budget deficit to widen out to further during 2012, although the precise level will depend on whether the new government uncovers further budget problems as it did in the regional elections earlier this year. The wider Spanish budget deficit underlines the paradox of thrift within Europe, where fiscal austerity is forcing all governments to save and Austrian-style debt devaluations and bank recapitalisation is forcing banks to accelerate the deleveraging of their balance sheets. In recent weeks, European banks have announced €1tr worth of balance sheet contraction over the next few years.

Europe is the ugly sister of the global economy and we expect real GDP to contract by 0.5% during 2012, and providing further proof of Winston Churchill’s famous statement that “trying to tax your way to prosperity is like standing in a bucket and trying to pull yourself up by the handle”. This forecast expects activity to contract in all of the PIIGS. We also expect French growth to contract by 0.3%. European recession is evident in the latest flash PMI estimates, which showed the composite estimate slowing to 47.3. Based on historical correlations this is equivalent to a 1% contraction in European GDP during the fourth quarter compared to consensus expectations of a 0.2% increase.

The predictive ability of these qualitative business sentiment indicators is less than in the Great Moderation, but nevertheless the data is consistent with other leading indicators pointing to European recession. As this stage we expect Germany to avoid recession next year, but French GDP is expected to contract. The flash composite PMI index for France declined to 46.8 in October. The unemployment rate reached 9.9% in September and is likely to rise further to 11% by the end of 2012. The Bank of France’s quarterly manufacturing survey showed a deterioration from +16 to +2 over the past three months, whilst the French Professional Association of Treasurers survey of corporate borrowing conditions, the net balance has sequentially deteriorated from +1.4% in July to -4.9% in August and further to -11.1% in September and -28.1% in October as French banks have increasingly struggled to achieve wholesale funding at economical rates. Bank funding guarantees will help alleviate this pressure over the next few months and should prompt some easing of these extremely tight credit conditions. However, we believe that this marks the difference between the relatively mild contraction of French GDP of 0.3% and a deeper contraction of 1.5-2.0%. French recession is likely to be the final nail in the coffin for the sovereign triple AAA as well as providing Nicholas Sarkozy with plenty of free time to spend with his new daughter after next spring’s presidential elections.

According to the politicians, Europe’s seventy systematically important banks require only €106bn additional capital to meet the new elevated core tier one capital target of 9%. The estimated national breakdown suggests that French, Spanish, German and Italian banks will need to raise €8.8bn, €26.2bn, €5.2bn and €14.8bn over the next eight months. It is clear that these figures have been chosen on the basis of what their respective governments deem to be affordable rather than necessary and given the reasonable concerns over the French banking system, it is clear that these estimates are too long and that the IMF’s estimate that at least €200bn was required seems much more reasonable. European bank balance sheets total $55tr, more than four and a half times European GDP.

In addition to national bank funding guarantees, ECB is expected to provide unlimited liquidity to partially alleviate these funding pressures and we expect a 50bps point cut in the official two week refinancing rate back down to 1.0% at the central bank’s before the end of the year, reversing the ridiculous hikes in the second and third quarters. This will not be enough to prevent recession in the periphery and France. Europe has a growth crisis; debt is manageable as long as there is sufficient growth to finance this debt. But debt also has a negative feedback loop in that too much debt dampens potential growth. Table 3 is taken from a recent study by the Bank for International Settlements entitled the Real Effect of Debt. This shows that Italy, Spain and Portugal all have combined debt levels of more than 300% of GDP. Ironically, Greece has the lowest combined debt of the peripheral countries on this metric, but the concentration of debt in the sovereign and the rapid rise over the past few years’ means that it has been the first domino to fall.

Ireland is not included in this survey, but it also has combined debt levels of more than 300% as well as financial sector debt of more than 400%. The abstract provided a neat summary of its findings noting that at moderate levels, debt improves welfare and enhances economic growth, but high levels can be damaging. This debt curve suggests that the point of inflection for government debt is 85%, supporting the finding of Kenneth Rogoff and Carmen Reinhart in their seminal work “Eight Centuries of Financial Innovation – This Time it is Different”, who found a material impact at 90% of GDP. However, the authors Stephen G Cecchetti, M S Mohanty and Fabrizio Zampoli have extended this analysis to corporate and household debt, indentifying levels beyond which they become a constraint upon growth. When corporate debt rises above 90%, while for household debt, the threshold appears to be around 90%. Europe has too much of this debt and it is strangling growth. A substantial portion of this debt has to be written off through debt devaluation before these economies can produce self-sustaining growth.

This study coupled with the austerity being imposed by creditor nations will force Europe justifies our belief that Europe suffer a prolonged period of recession and deflation. Germany intention to force the rest of Europe to follow its model of substantial current account surpluses is ultimately self-defeating. This tries to apply an individual open economy model of Germany to the seventeen economies within an economic system that is essentially closed with a smaller share of exports as a percentage of GDP than the US. The resulting savings surplus will provoke the paradox of thrift and contribute to price deflation and currency appreciation. This deflation is likely to be made worse by mercantilist policies from the developing economies that seek to boost the €uro at the expense of the US Dollar and the ECB’s refusal to monetise Europe’s vast debts. The Bank of Japan’s refusal to take the necessary steps to weaken the Yen has played a crucial role in prolonging Japan two decades and counting period of very weak growth. The fourteenth emergency summit has done little to halt the withdrawal of private capital from the periphery and in forcing an inadequate “voluntary” haircut on Greece have established a principle and mechanism from which there will be regular and widespread debt devaluations across the periphery.

Yesterday’s agreement therefore produced an unstable equilibrium between hope and despair and we do not believe that the relief rally in risk will persist beyond the next few weeks. Indeed, the next crisis is necessary to force the political and legal changes required to allow full fiscal union and central political control of government budgets. The political morass that this produces will be the true test of the political elites and their increasingly reluctant electorates to follow the dream. We believe that as a political construct the single currency’s career will ultimately go the way of all political careers and we remain overweight the true triple AAA economies of Germany, Holland and Finland.