The Fear Gauge in the Eurozone
Funding fears, political gridlock and plunging stocks have pulled the eurozone deeper into crisis. On Friday, the gauges of market stress continued to widen signalling more turbulence in the days ahead. Libor –the rate at which London-based banks borrow from each other–increased for the eleventh straight day, while the Libor-OIS spread, (which indicates the reluctance of banks to lend to each other) soared to levels not seen since Lehman Brothers blew up in 2008. And the VIX–better known as the “fear gauge”–has been surging for more than a week.
What does it all mean?
It means the eurozone is in the throes of a vicious credit crunch, but its leaders are frozen in the headlights. That’s a recipe for disaster.
This is from a report by the ECB: “Greatly increased fiscal imbalances in the euro area as a whole and the dire situation in individual member countries risk undermining stability, growth and employment, as well as the sustainability of EMU (Economic and Monetary Union) itself.” (“Warnings mount on euro crisis, credit crunch”, Reuters)
The risks of a disorderly breakup of the eurozone are now greater than ever. Greece is bankrupt and headed for default, but finance ministers can’t agree on a way to ringfence the teetering country to stop the contagion. Indecision and foot-dragging have roiled global equities and cleared the way for more carnage. Last week’s downgrades of two French banks have increased worries about the solvency of the EU banking system. This is from the Telegraph:
“The Bank for International Settlements has calculated that European banks have a $4 trillion “funding gap” – the shortfall between deposits and the long-term loans they have made and a concept that dominated the build up to the credit crunch. The IMF reckons European lenders are sitting on Eu300bn of credit risk.” (“Plan B: Flood the markets”, Telegraph)
Doubts about the EU banking system have sent the financials into freefall while the prospect of “cascading defaults” and deflationary pressures loom ever larger. Leaders will either have to be proactive or accept the consequences of their inaction.
For weeks, the news from Europe has been uniformly bleak. Italy was downgraded by Fitch ratings agency last Monday, while the Financial Times reported that “Siemens withdrew more than half-a-billion euros in cash deposits from a large French bank two weeks ago and transferred it to the European Central Bank…The German industrial group withdrew the money partly because of concerns about the future financial health of the bank and partly to benefit from higher interest rates paid by the ECB, a person with direct knowledge of the matter told the Financial Times.”
The Siemens incident shows that confidence in French banks is beginning to wane creating doubts about the ECB’s ability to act as lender of last resort. Then there’s this from Reuters:
“A big market-making state bank in China’s onshore foreign exchange market has stopped foreign exchange forwards and swaps trading with several European banks due to the unfolding debt crisis in Europe, two sources told Reuters on Tuesday.
“Apart from spot trading, all swaps and forwards trading (with the European banks) have been stopped,” one source who is familiar with the matter told Reuters.” (“China bank stops FX swaps, forwards with some European banks”, Reuters)
And, this from Bloomberg:
“Lloyd’s of London, concerned European governments may be unable to support lenders in a worsening debt crisis, has pulled deposits in some peripheral economies as the European Central Bank provided dollars to one euro-area institution.
“There are a lot of banks who, because of the uncertainty around Europe, the market has stopped using to place deposits with,” Luke Savage, finance director of the world’s oldest insurance market, said today in a phone interview. “If you’re worried the government itself might be at risk, then you’re certainly worried the banks could be taken down with them.” (“Lloyd’s of London Pulls Deposits From European Banks as Confidence Withers”, Bloomberg)
Former U.K. Prime Minister Gordon Brown reiterated the claims of IMF chief Christine Lagarde that European banks are “grossly under-capitalized” and that the current debt crisis is more serious than the Lehman meltdown in ’08.
Late Thursday, the Financial Times reported hopeful news that EU officials were planning to recapitalize underwater banks. According to FT.Alphaville:
“European officials look set to speed up plans to recapitalise the 16 banks that came close to failing last summer’s pan-EU stress tests as part of a co-ordinated effort to reassure the markets about the strength of the 27-nation bloc’s banking sector.
A senior French official said the 16 banks regarded to be close to the threshold would now have to seek new funds immediately.” (“European bank recap recap”, FT Alphaville)
It sounds promising, but there’s one caveat. The sum that’s being discussed is too small to buffer the banks from a severe downturn. Thus, the story appears to be more public relations than a viable solution.
EU banks are also seeing the costs of dollar funding rise again. Despite the combined efforts of the Fed and other central banks, the growing likelihood of a Greek default has, once again, increased the price of swapping euros for dollars. The added expense puts more pressure on already-weak balance sheets at EU banks. This is from Pragmatic Capitalism:
“The ECB’s dollar program has also failed to halt the trend toward shunning European borrowers in the commercial paper market, a trader at a primary dealer in New York said.
European firms, particularly banks exposed to Greek debt, are stuck with only the shortest-term loans unless they’re willing to pay high premiums. (“Dollar funding costs rise”, Pragmatic Capitalism)
The Fed’s massive currency intervention fizzled less than 24 hours after the program was announced. That’s got to be a record.
So, conditions in the eurozone continue to deteriorate. Bond yields on sovereign debt continue to rise, money markets and commercial paper markets are under attack, insuring against default is getting more expensive, bank withdrawals are increasing, and interbank lending is grinding to a standstill. Even so, according to the UK Telegraph, EU officials have concocted a secret plan to recapitalise the banks and save the eurozone from disintegration. Here’s an excerpt from the article:
“European officials revealed they were working on a radical plan to boost their own bail-out fund, the European Financial Stability Facility (EFSF), from €440bn (£384bn) to around €3 trillion.
The plan to increase the EFSF firepower (note: through massive leverage) is the crucial part of a three-pronged strategy being designed by German and French authorities to stop the eurozone’s debt crisis spiralling out of control. It also includes a large-scale recapitalisation of European banks and a plan for an “orderly” Greek default….
The plan, which would aim to build a “firebreak” around the indebted eurozone countries, emerged at the IMF annual meeting in Washington where global leaders united to demand urgent action from European politicians.” (UK Telegraph)
Whether the plan is real or just wishful thinking is anyone’s guess, but, so far, there’s no sign that Germany has budged on any of the main issues. Merkel remains opposed to eurobonds”, opposed to blanket bailouts for countries that don’t meet their austerity targets, and opposed to a supra-national fiscal authority that can act as as the monetary union’s treasurer.
And even if the German Chancellor chose throw her weight behind the US proposal (Treasury Secretary Timothy Geithner wants to massively leverage the emergency fund to $2 trillion in order to create a de facto EuroTarp), she would face stiff resistance at home from adversaries at the Bundesbank (Germany’s central bank) and in the courts. In other words, Merkel’s hands are tied. The German parliament will support a larger emergency fund, but there will be no blank checks for banksters or unsterilized quantitative easing. (“monetization”)
As goes Germany, so goes the 17-member monetary union. But Germany is not following Wall Street’s script. They have their own ideas about these things. That’s good for working people but probably fatal for the eurozone.
Mike Whitney lives in Washington state. He can be reached at firstname.lastname@example.org