German parliamentarians reaffirmed their commitment to the Euro-project on Thursday by approving an expansion of the European Financial Stability Facility (EFSF). The balloting provided the landslide victory (523 to 85) that German Chancellor Angela Merkel needed to reestablish her leadership and to silence dissidents. The bill will increase the size of the emergency fund (from $340 billion to $600 billion) while allowing greater flexibility in the way in which the funds are distributed. Officials are now free to recapitalize struggling banks as well as purchase bonds from nations that have seen yields spike and government debt soar.
According to Der Speigel:
“… the law passed on Thursday includes a provision which gives the German parliament a say in future EFSF decisions. In a recent verdict, Germany’s highest court had demanded greater parliamentary involvement in decisions relating to euro-zone bailouts. And now, a special committee will be established in the Bundestag to ensure parliamentary involvement even in hurried EFSF resolutions.” (“German Parliament Passes Euro Fund Expansion”, Speigel Online)
The importance of the Bundestag’s “special committee” can’t be overstated. The representatives of the German people will now have a veto-power over policies related to the emergency fund. That means that the fund won’t be “massively leveraged”–to meet the bond purchasing needs of Spain and Italy–unless the new committee agrees. And, agreement would be difficult for anyone seeking reelection in Germany where public opposition to more bailouts is overwhelming. So, while Merkel has won a crucial victory in the short-term, the future of the eurozone is more uncertain than ever.
This is from Bloomberg:
“Global investors anticipate Europe’s debt crisis leading to an economic slump, a financial meltdown and social unrest in the next year with 72 percent predicting a country abandoning the euro as a shared currency within five years, a Bloomberg survey found.
About three-quarters of those questioned this week said the euro-area economy will fall into recession during the next 12 months and 53 percent said turmoil will worsen in a banking sector laden with government bonds, according to the quarterly Global Poll of 1,031 investors, analysts and traders who are Bloomberg subscribers. Forty percent see the 17-nation currency bloc losing at least one member in the next year.
More than a third of participants say deteriorating European debt will derail the world economy over the next year, with the pessimism highlighting the pressure European policy makers face as they try again to fix their 18-month sovereign crisis. Stocks last week tumbled into their first bear market in two years and foreign leaders, including President Barack Obama, are urging European leaders to intensify their rescue efforts.” (“Europe Meltdown Seen Converging With Recession”, Bloomberg)
So, the outlook is still pretty gloomy. Merkel’s triumph hasn’t changed the basic eurozone dynamic; the monetary union’s structural problems still persist. The EFSF just glosses over the problem by sticking a big pile of money in front of investors saying “See how committed we are!” That’s quite a bit different than providing blanket guarantees on government debt or backing state bonds with the “full faith and credit” of the United States of Europe. Any real solution requires credible government institutions that underwrite state debt. A mountain of money doesn’t achieve that goal.
And while its true that bond yields are rising in Spain and Italy because the rate of debt-to-GDP is high, part of the increase is due to investor jitters that there is no lender of last resort (as there is in the US or any other sovereign country that pays its debts in its own currency) And when there’s no lender of last resort, then how can bondholders be certain they will be repaid? Keep in mind, people who buy government bonds, do not do so for the high rate of return, but because they don’t want to worry about getting their money back, which is why government bonds are commonly called “risk free” assets.
Are Italian bonds risk free assets if repayment depends on the whims of German parliamentarians?
The EFSF has been called Euro-TARP, which is a fair description. But TARP was just one of many programs that kept the financial system from experiencing even bigger tremors. The Fed also purchased over $1.25 trillion in mortgage-backed securities (The so called “toxic assets”) and created a myriad of lending facilities to backstop all parts of the financial system, including blanket underwriting of dodgy assets traded by unregulated shadow banks.
Is the Bundestag prepared to do the same?
And what about the markets? While the reaction to the balloting is bound to be equities-positive, will it relieve the pressure that’s been building in the credit markets where the real troubles lie?
Not likely. Earlier in the week, global markets rallied for two full days on a rumour that turned out to be false. CNBC market analyst Steve Liesman reported that a “detailed plan is currently in the works on levering the money from the European Financial Stability Facility (EFSF) … Under the plan the European Investment Bank (EIB) would form a Special Purpose Vehicle (SPV) to issue bonds and purchase sovereign debt with the bonds it used so it could take the capital from the EFSF lever up these bonds could also be used as collateral at the European Central Bank (ECB).”
That’s the rumor that sent stocks into the stratosphere. Traders loved the idea that the emergency fund would be transformed into an Enron-type perma-leverage-machine that could amplify the original sum of 440 billion euros by 5 or 10X. But, as it happens, the report was wrong.
This is from Bloomberg:
“The European Investment Bank said is has not been approached concerning a reported plan involving a special purpose vehicle connected wi th the European Financial Stability Facility for the purpose of bailouts.
“There have been media reports about a potential involvement of the EIB in a special purpose vehicle in connection with the EFSF, for the purpose of bailouts,” the EIB said today in a statement. “The EIB has not been approached and has no plans to be involved in this. The EIB will continue to focus on its mission which is financing viable investment projects.” (Bloomberg)
So, no mega-bailout fund, after all?
The point is, that while stocks were flying-high, the credit markets were still blinking red. For example, Libor continued to rise during the rally and through today (Thursday) for a 15th straight day. In other words, the cost of borrowing dollars and euros for three months in the London interbank market is still going up. At the same time, yields on Spanish and Italian debt continue to rise to new highs.
This is from euronews:
“Italy was able to sell 14.5 billion euros worth of short-term government bonds in its latest debt auction on Tuesday. But Rome again had to pay higher rates of interest to raise most of that money….Spain also paid higher borrowing rates as it sold 3.2 billion euros of new short-term debt.” (euronews.net)
The TED spread has remained elevated at 36 basis points, another sign of distress. And, according to Bloomberg:
“The ECB said financial institutions increased overnight deposits. Banks parked 165 billion euros ($225 billion) with the Frankfurt-based lender yesterday, compared with 151 billion euros on Sept. 23 and 198 billion euros on Sept. 12, the ECB said.”
Overnight deposits are a sign that banks are too distrustful about the solvency of other banks to leave it with them. And what about EU bank funding; is that still a problem?
Yes, a bigtime problem. Take a look at this from the Wall Street Journal:
“An extraordinary dry spell in the market for long-term European bank funding is amplifying pressure on policy makers to devise a solution to the Continent’s banking crisis.
For the past three months, European banks have been largely unable to sell debt at affordable prices to investors, who are wary of the banks’ vulnerability to risky euro-zone government bonds and other loans.
At $34 billion, the amount of senior unsecured debt issued by the Continent’s financial institutions this quarter is on track to be the smallest of any quarter in more than a decade, according to data provider Dealogic. Most of those were bite-size deals of less than $500 million apiece. Traditionally, issuing such debt has been among the most popular ways for banks to finance themselves over the long term.”
Now market observers are worried that the funding freeze is going to continue and perhaps worsen heading into 2012, with potentially serious repercussions for the banking industry. (“Europe’s Banks Face New Funding Squeeze”, Wall Street Journal)
Or how about this, again from another article in the Wall Street Journal:
“European bank funding markets are in the deep freeze, with no public senior euro issuance since early July. That is becoming a major problem: Three-quarters of financing for Europe’s economy comes from banks, according to the European Central Bank. Restoring access to long-term funding must be a priority for Europe’s policymakers.
Bank bond issuance has collapsed as the sovereign crisis has deepened….Fear of sovereign defaults risks a vicious circle where banks unable to borrow then cut back on lending. That crimps growth prospects and increases the risk of sovereign solvency problems.
The International Monetary Fund estimates that spillover costs from the turmoil in government bond markets could amount to EUR300 billion and calls have mounted for banks to raise fresh capital. But this alone is unlikely to reduce funding costs and boost issuance: If the fear is one of widespread sovereign defaults, including heavyweights such as Spain or Italy, it is difficult to imagine enough capital could be raised to withstand the subsequent havoc….
The longer the euro area dithers, the worse the downturn is likely to be. (“Bank Funding, Not Capital, Must Be Priority”, Wall Street Journal.)
Get the picture? No sane investor would touch EU bank debt with a 10 ft. dungpole. So, who are you going to believe; the stock markets or the credit markets? The truth is, troubles in the eurozone are getting worse not better.
Still, there’s no doubt that EU leaders will use Merkel’s victory to try to make changes to the emergency fund that will allow for more leverage. Even so, the enhanced bailout plan is likely to meet stiff resistance on the way. According to one report, German opposition party leader on budget issues, Schneider, has warned Merkel that “any introduction of leverage that would not feature explicitly in the EFSF reform bill discussed and voted on this Thursday in the Lower House would be a de facto circumvention of Parliament, and that this would simply be unacceptable to the SPD.” (“The ‘No More Lehmans’ rally”, FT.Alphaville)
So, there are going to be more hurdles, more legal challenges and more public resistance to the bailout fund. And while the expanded bond purchasing program will undoubtedly have positive effects on debt-stricken countries in the south (and credit markets), austerity measures will continue to short-circuit private sector spending leading the way to higher unemployment, slower growth and an ever-deepening slump. The eurozone is headed for recession.
The 17-member monetary union has structural problems that can’t be resolved by holding down bond yields and propping up banks. Either the problems are fixed or the eurozone won’t survive.
Mike Whitney lives in Washington state. He can be reached at email@example.com