The delayed reaction to the ECB’s three year long-term repo operation has provided a powerful boost to peripheral government bond markets. The ECB initially disappointed investors who were looking for the central bank to announce unlimited quantitative easing similar to the Fed and the Bank of England, which involves sustained and substantial purchases of member government bonds, but extended terms of the three year repo have provided substantial liquidity and contributed to the 42% expansion of the ECB’s balance sheet over the past eight months.
The ECB’s balance sheet now represents 29% of €urozone GDP and is a similar size to the Bank of Japan’s ratio, although it has taken more than thirteen years for the BoJ to achieve the same level. The ECB’s balance sheet will expand further in February when the central bank conducts a second 3yr LTRO. By contrast the Fed and MPC’s balance sheets are equivalent to around 20% of GDP although we expect both balance sheets to expand substantially over the next twelve months. In theory there is no limit to the size of the central bank’s balance sheet, the Swiss National Bank’s balance sheet is more than 60% of GDP and is likely to rise even further to constrain the Franc against safe haven flows from the €urozone. We expect the €uro to fall to $1.15 against the Dollar by the middle of the year.
Moreover, it is logical for the ECB to have a substantially larger balance sheet as a percentage of GDP because of the size and importance of banking in Europe relative to the US. However, logic and politics are strange bedfellows and we believe that the Northern European members of the ECB’s governing council will become increasingly uncomfortable with the scale of the central bank’s liquidity provision. After February, 3y LTRO’s will be reserved for emergencies, which will undoubtedly arise during 2012. The ECB has not completely exhausted other avenues of stimulus, we believe that the ECB has further room to cut its benchmark two week repurchase rate further from the current 1.0% rate down to 0.5% by the end of the summer. However, we view 50bps as the lower limit for rates in Europe because of the impact on money market funds and t-bill rates. These interest rate cuts will contribute to further €uro depreciation and we expect the currency to drop to $1.15 against the US Dollar.
The ECB’s additional liquidity measures have prevented systemic failure of the European banking system. Banks will have sufficient funding to cover their refinancing needs during 2012. Sentiment amongst peripheral government bond markets has gained additional confidence from the sudden and sharp improvement in business sentiment over the past two months. Citibank’s Eurozone economic surprise index has risen from -60 in mid-November (itself an improvement on the -104 in early September) to the current level of 27. We believe that these positive surprises relative to market expectations could continue for another couple of months, raising the surprise index to 60-65 level. This will be driven almost entirely by special and temporary factors caused by the mild winter weather and increased economic volatility in the wake of the credit crunch, although there has undoubtedly been some positive lagged impact from the weaker €uro since last summer. Both of these temporary factors are extremely difficult for statisticians to accommodate in the monthly data and will have the effect of optically boosting activity in the first quarter and depressing it in the second and third quarters. This pattern will be extremely important for European economies since the initial relieved euphoria gives way to heightened pessimism in the spring and summer.
This combination of generous ECB liquidity and temporary seasonal boost has solved the liquidity crisis in the short-term, but it has not liquidated the solvency crisis in the longer term. Europe has a balance of payments crisis that has been aggravated by fixed exchange rates within the single currency. The German solution to this balance of payments crisis has been severe and rapid fiscal austerity, which has fostered the paradox of thrift within the region. This is forcing deep recessions on the peripheral economies, which are ultimately self-defeating as the following summaries of the PIIGS.
Greece: Greece is bankrupt and will have to default. Debt to GDP is 165% and is expected to rise to 180% by the end of the year. We expect the budget deficit to remain close to 10% of GDP as growth contracts by an additional 5% (on top of the 12% contraction over the past three years) as the persistent recession and sluggish reform process fails to provide any material fiscal improvement. We do not believe that there is an acceptable level of voluntary private sector net present value debt reduction that returns Greece to a sustainable growth path. More money is required either from the ECB, European Governments or private sector investors. All of these participants are reluctant to send good money after bad. The first opportunity to default is the March 20th redemption, and while it is possible for either the ECB or more likely the politicians to provide more money to jump this hurdle, the combination of elections in April and further economic weakness will force default by the summer. In the wake of this expected default, it remains to be seen whether the Eurozone will continue funding Greece, but if it does not, Greece will be forced to leave, enduring the resulting chaos.
Portugal: Is the next domino to fall. The Government missed last year’s deficit target of 4.5% by 1.4%, this means that it now has to halve the budget deficit to meet the Troika’s target of 3.0%. This will be impossible with another substantial contraction of growth. We expect growth to contract by 4.5% during 2012, with the official data contracting by even more as tax evasion follows the same route as Greece. Portugal is poorer than Greece, per capita income of $21,000 versus $26,000 and more indebted, with total debt equivalent to 479% of GDP, compared to 296% in Greece, although government debt is lower at 110% of GDP. There is no doubt that Portugal will need another package. This package will have to be agreed before the country is scheduled to return to the markets in May 2013. From May 2012, the IMF will have to provide an assessment of the forward funding ability. The second package needs to be at least as large as the €79bn provided in May 2011. This will be funded by the ESM, which in turn will include a collective action clause and suggests that even if the European authorities decide not to force private sector debt holders to share the burden through PSI, they will eventually have to be expropriated because the debt is too high for Portugal to repay.
Ireland: A second Portuguese package will also focus attention on Ireland. Ireland is the poster child of austerity even carrying out a debt swap. Irish government bond yields have more than halved since last July when the agreement to provide a second Greek bailout package also reduced substantially the interest rate that Ireland paid for its bailout. Irish government bonds have also been helped by the fact that prior to the crisis, the outstanding level of Irish bonds was relatively low and over the past six months, when there has been no new issuance there has been strong demand for the paper from domestic pension funds and banks. So far so good, but Ireland debts are still too high and there is pressure in the government to repudiate the bank debt that it acquired in 2010. The economy is crucial, domestic demand remains very weak and growth has been driven by exports, this is reflected in quarterly GDP last year which rose by 2% in the first and second quarters and contracted by 2.0% in the third quarter and over the previous four quarters, GDP contracted by 0.1%. Nevertheless, the Government is confident that the economy will grow by 1.3% during 2012 despite the latest IMF forecast of 0.5%. We believe that weak global growth will cause GDP to contract by 1.3%, consistent with the cyclically adjusted fiscal tightening of 1.3% of GDP and this will provide the catalyst for Ireland to “renegotiate” its guarantee of bank debt and seek substantial haircuts on these bonds.
Spain: Spain has already funded 20% of borrowing requirement this year encouraging its banks to borrow as much liquidity from the ECB to reinvest in government bonds. However, beyond the February LTRO, there is a limit to how much Spanish banks can increase their holdings without raising concerns amongst investors. More importantly, the government’s recent package increased the cyclically adjusted tightening of policy to 1.9% during 2012, with an additional tightening of 0.6% due in 2013. The IMF has responded to this additional austerity by lowering its forecast for 2012 from growth of 0.9% to expecting a contraction of 1.7% in just four months. The contraction in growth will lead to a further increase in unemployment from the current 22.3% to more than 25% over the next couple of years. Rising unemployment will put further downward pressure on property prices. The budget deficit exceeded its 2011 target of 6% by 2% and it will be impossible to meet the 2012 target of 4.4%. Spanish banks are exposed to domestic property, over-leveraged corporate sector and Portugal. The government has acknowledged the need to recapitalise the banks by €50bn, but we believe that the requirement will be at least three times this level. This cannot be achieved through domestic resources and we believe that this will require recourse to the ESM to fund this bank bailout. Use of the ESM will result in further sovereign credit downgrades.
Italy: The IMF has just downgraded its outlook for Italian GDP to predict a contraction of 2.2% during 2012 noting “overdoing fiscal adjustment in the short-term to counter cyclical revenue losses will further undermine activity, diminish popular support for adjustment and undermine market confidence”. Policy tightening will be equivalent of 2.1%, with half of the austerity caused by tax hikes. These counter-productive policies will reduce growth and damage support for the technocratic government. However, Italy is too big to fail and too big to bail. Debt to GDP is equivalent to 120% of GDP and the growth and policy outlook suggests that this will rise to 130% by 2015. If Germany refuses to allow common Eurobonds and unlimited ECB bond buying, and we believe that they will be because they are illegal under current treaties; then Italy’s excessive debt burden will have to be reduced. This debt devaluation is likely to take place within the euro, because of the scale of Italy’s $1.9tr government bond market, but the cost of this devaluation will require further bank recapitalisation by the ESM.
In conclusion, we expect the single currency to eventually break up, but it is likely to be a long, slow, lingering death rather than a rapid collapse. The single currency is likely to lose at least one member during 2012. The most likely candidate is Greece and this is likely to be followed by Portugal within the following twelve months, which in turn will put pressure on Ireland. The European authorities will be forced to ring fence both Spain and Italy, but this will require a substantial transfer of resources from the richer northern European economies. We believe that voters in these economies will eventually rebel against this implicit taxation without representation and one of these countries will leave the single currency. This analysis may seem unnecessarily pessimistic, particularly to those who believe that the history of Europe is one in which the business elites drag politicians towards greater federalism, and therefore by hook or by crook the €uro will survive, either unlimited purchases of peripheral government bonds by the ECB or through issuance of common Eurobonds. Proponents of the latter solution note that German politicians are not opposed to Eurobonds and would be willing to offer support provided there is greater central control over the new fiscal compact. However, the German Constitutional Court has made it clear that it would require a referendum to allow Eurobonds and unlimited purchases of peripheral government bonds that are contrary to the ECB’s treaty. More importantly the fiscal compact creates pro-cyclical policies in a region that has too much debt, government, financial, consumer and corporate. This is not sustainable in the medium term.
Chief Economist, Co-Fund Manager
Jan 31, 2012 at 2:15pm