The US and Russia are gaining traction on an economic rebound, with China posting rudely healthy 1Q 2010 GDP growth. But its time for Europe to get ready for Recession - the sequel.
Jean Claude Trichet is an urbane, intelligent and eminently reasonable man, and the ECB he leads has, as he rightly pointed out during Thursday's Lisbon press gathering to announce a non rate movement, done a sterling job in defending the Eurozone against inflationary pressures for the better part of a generation.
But there was an air of surrealism that the late Luis Bunuel would have enjoyed. There were the press representatives all revved up for quick and punchy responses to the emerging contagion and what the ECB could offer. What they got was the ECB President languidly going on about Eurozone growth and inflationary pressures, and keeping the Eurozone budgetary house in order. He offered nary a word of substance about the fire which has broken out in its Greek kitchen, and even less in recognition of the potential for the curtains in its Mediterranean sunrooms to become part of the conflagration. It was sort of like a man reading out a weather report involving light breeze, some cloudy patches and fine and mild conditions in general – whilst on fire, and in heavily French accented English.
The truth be told, nothing more should be expected of him. His job is, as head of the ECB, to keep inflation rates at or about 2% first and foremost, issue warning about potential deviations from the inflationary comfort zone, and bend ECB monetary policy to maintaining or seeking it. He shouldn’t be expected to don red underpants and cape and try to be superman.
What he did say was that default wasn’t an option as far as he was concerned for Greece, but he also couched that by noting it was up to Greece, the nations lending to it, and the IMF to come to an arrangement to head that off. When asked directly about whether inflation or the Euro was the prime focus for the ECB, he was emphatic about the former.
Somewhere in the back of his mind however he must surely be countenancing the possibility of a further return to recession in Europe, and the likelihood that in the medium term he will need to cut rates once again in order to head off deflation rather than inflation, and to try again to get the Eurozone some traction on an economic recovery.
Borrowing costs heading north
For the simple matter is that the Greek debt, and the Eurozone response to it, is already starting to lift borrowing costs, and they could indeed jump considerably higher if the contagion he didn’t want to speak about yesterday were to, as appears increasingly possible, take hold in Spain, Portugal and Italy in particular.
This week already sees overnight and 3 month dollar LIBOR up, along with the LIBOR-OIS spread, as ‘Club Med’ CDS have widened sharply, and Greek Portuguese and Spanish government bond yields have pushed higher – to record levels for the latter two against the 10 Year German Bunds. A couple of screens away one can observe Greek three year bonds rising from 11-17% in a week, and other 3 year bonds from Spain and Portugal up a percent. Whilst it isn’t Lehman Brothers panic mode, there is still some way to go, and there is a faint whiff of counterparty risk coming from somewhere.
Lots of Eurozone debt
The reason for this is quite simple. A lot of Europe has far too much debt, and most nations have structural budget deficits adding to it. Greece might be out in front, but Portugal, Spain and Ireland are in the pack not far behind it, and the Italians are at best a half length behind them. The exposure of European banks to these nations is well over 2 trillion dollars. 2 trillion is also the total European debt rollover requirement of this year, with more than a trillion of that belonging to the Club Med watching their yield and CDS needs start to get pointy. Spain alone is mulling more than $550 billion.
Now at this point the first thought is that the Germans are the first logical place to look in terms of bailing all of this out and making sure that the liquidity keeps flowing. Notwithstanding the quite reasonable concerns of German taxpayers about bailing out what they see is profligate sun drenched laggards, and the pragmatic thought that German banks are amongst those where the money will end up, which is essentially socializing potential losses for them, with those same taxpayers picking up the tab, there is another fly in the ointment. Last year Germany passed a law limiting its federal government budget deficit to 0.35% of GDP from 2016. That means that opening the sluices now to help anyone too much could pressure that need.
This leaves – without wanting to point fingers of blame at anyone – a dysfunctional Eurozone large in any consideration of the future. And that counterparty risk starts to take a more overt shape.
Euro Banks bracing for a hit
Any possibility that Greece, and then possibly other nations, may either default, or restructure in some other way, is going to see the lenders – the banks – get less in the Euro than they are currently exposed for. That means potentially large writedowns. From there the next logical step for the banks is that they lend a lot less, and presumably jack up interest rates on what they have already lent. In the case of European banks there is an added issue in terms of their underlying capital base, which is in many cases less than their US counterparts. So that leaves the prospect of either a financial sector tightening due to higher borrowing costs for the state and major lenders, if not a financial sector tightening due to capital flight, a financial sector tightening due to banks having holes blown in their balance sheets, writedowns, or in the worst case, financial sector tightening due to banking collapses and corporate or state insolvencies.
With the increasing likelihood that Eurozone banks are likely to take a hit one way or the other, there isn’t a great deal the ECB can look to do. It could look to monetize debt by printing money, but that would let the inflation dog out of the bag and involve a lengthy negotiation process with a number of politicians from across the EU to get agreement on. It could look to buy any debt from banks and try and get banks in turn to buy sovereign debt, which would be the first step in taking over whole national banking systems and presumably would require a lot more lengthy political discussion – and Trichet did note at Thursdays press conference that the move to help Greece out this way announced last weekend had been arrived at as a one off. If the process of getting a game plan together for the Greeks together is any indication then any political approval process is likely to take time.
Mire the mail
In the short term, with costs already rising for the borrowers of Europe, the austerity measures now being asked of in Greece are unlikely to be the last asked of inside the Eurozone. It is now time for Europe to start thinking in terms of that return to recession, and how to minimize the impact, and for the global economy to look further afield for drivers of growth, while hoping the contagion, and likely financial chaos, can be fenced off.
Citigroup is also bearish, predicting that fears of sovereign debt contagion over Greece could trigger a near-term correction of up to 20%. They said that while there have been financial crises with international implications in the recent past -- Northern Europe in 1992, Southeast Asia and South Korea in 1997 -- the Greek crisis is "graver than these were."
The worst crisis to befall the euro area has led economists at Societe Generale SA and Royal Bank of Scotland Group Plc to suggest the ECB should consider the “nuclear option” of buying government bonds to restore confidence in markets, support banks and lower borrowing costs:
My thoughts are that the ECB is already behind the curve, allowing speculators to attack sovereign debt of fiscally vulnerable European nations.
At this juncture of the crisis, there are only two choices: 1) do nothing and let the world sink into a deflationary hellhole or 2) do anything it takes to shore up the global financial system and look to restructure debt as the world economic recovery gains traction.
I believe the Fed and the ECB will opt for the second choice. There will be protests, some people will worry about inflation, but when facing a choice between two evils, central bankers will opt for reflation-inflation over debt deflation.
Take the time to watch Charlie Rose's interview with Barton Biggs, Byron Wien and Roger Altman and then watch the Bloomberg interviews with Rod Smyth, chief investment strategist at Riverfront Investment Group and John Herrmann, a senior strategist at State Street Global Markets.