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Saturday, 10 December 2011


The Euro like many great but complicated projects has different storylines. There are the simple versions for general public consumption and what politicians find to be useful sound-bites that are difficult to challenge technically, and then there are the more complex deeper reasons that risk technical arguments beyond the capacity of most politicians to master and that are therefore deemed suspiciously suspect because they are above the capacity of the public to usefully (politically) understand. The consequence is policies promoted for misleading even spurious reasons.
The reasoning that led to creation of the Euro and its support system the Growth & Stability Pact (also known as The Maastricht Criteria) had a number of political motivations including closer integration picture-framed by a few simple practical ideas for the public to understand such as easier cross-border trade and savings for tourists on currency conversion costs. The most important reasoning however was really to create a currency too big to be played with to the extent of its credit being severely damaged by the markets, a currency that would not suffer the blackmail of the markets as in the case of Sweden and the Nordic currency crisis of 1991-3, The ERM crisis of 1992-3, the Sterling crisis (termed "Black Wednesday") of September 1992 (and of some importance the Latin American currency crises of the late '80s and Mexico in 1994-5 and East Asian in 1997-9).
The first paradox therefore is that clearly the money markets have in fact been able to discredit the Euro system to such an extent that like the earlier ERM with its narrow bands it is struggling to survive. If it falls apart, partly or wholly, market speculators have a golden opportunity to make short term large gains by shifting in and out of different Eurozone countries' equities, bonds and currency holdings.
When the Euro was created (January 1, 1999) and in the months leading up to this date the money markets lost 10 interest rates, currencies and bonds differentials to trade in and out of. A lot of markets liquidity was lost and investment banking gross trading profits of several hundred $billions a year. Money had been made by aggressive speculators in the ERM (also known as currency snake) years. The essential ingredient facilitating successful speculation (including short-selling)is a rigid system with transparent rules that can be easily tracked by the markets. The narrow bands within which currencies within the ERM were allowed to move were manna to the speculators.
The second paradox therefore is that in creating the Euro to be resistent to market speculators it was furnished with rigid transparent rules in terms of maximum ratios of budget deficits and of gross national (government) debt as a % in ratio to GDP. In the first years of the Euro a certain latitude was permitted including in the case of the largest economy of the Eurozone, Germany. Following a brief Eurozone technical recession in 2008 (a shock response to the international Credit Crunch) it was obvious that the next speculative opportunity would be loss of confidence in soverign debt as measured by the Euro's ratio rules. Such sovereign debt crises have always been triggered after a recession when governments increase their budget deficits and national debts in order to pull their economies out of recession.
That this should be especially a problem for the Eurozone and Euro system was easily predicted by many experts, though ignored and voted down at several IGCs. The Delors Plan and European Recovery Plan both of which advocated a trillion Euros to smoothe differences between economies netering the Euro was voted down by Germany, Netherlands and UK when supported by all others. Germany and UK especially were adamently opposed to brussels getting its hands on such a large spending reserve.
The markets speculators have merely had to wait for the Euro's first important recession to test its structure. The experts doubted how any currency could be sustained through and after a severe economy downturn if it is not directly supported by government finances. The Euro was only supported by the European Central Bank whose flexibility is constrained and whose ability to respond to some countries problems more than others is politically and constitutionally limited.
Brussels economists planning for the Euro in the mid-1990s told me privately that they believed The Maastricht Treaty was too simple and too inflexible. But because of the political drive behind the Euro it would be a disaster to drop the Euro plan, a disaster to delay it, and a disaster to proceed with it! The politicians and others had painted themselves into a tight and unsustainable corner. It was hoped that after five years of low growth and higher unemployment against trend caused by The Euro's introduction that lessons would be learned and a more sophisticated system introduced. Such a system should take better account of different GDP growth paths of each national economy, allowing for some that were growing based on heavy bank lending to property thereby causing trade deficits and those were growth was predicated mainly on export surpluses and therefore on banking lending to industry.
In the first decade Greece for example was praised year after year for contributing to Eurozone GDP groth much above its weighting in the Eurozone economy. It did not matter that Greece ran up the biggest trade deficit in the OECD relative to its GDP. Current account (external) payments balances were not part of the Maastricht Criteria. Ireland benefited to from excessive praise. While its GDP seems to be growing fast because of its massive trade surplus relative to GDP, the fact that it had huge current account payments deficits (uniquely so) was ignored! The system of rules was too simple.
When the ECB and other central banks set interest rates there are rules and obligations at work. But they are flexible; matters of judgement that make the interest rate decisions very difficult for the markets to predict and to successfully speculate against. This ambiguity in how decisions are arrived at and what they mean is a very useful policy tool that became evacuated from the Eurozone, especially so once Germany (with alongside other net exporters) was no longer in breach of the ratio rules.During the Credit Crunch (not yet over) banks and later governments that refinanced their banks using government bonds (not bills i.e. on-budget, not off-budget) the great anxiety was to bring down the cost and raise the certainty of supply of loans to banks (to recycle their funding gap finance) and to governments (to keep borrowing costs in line or below that of the rate of GDP growth and of government revenue growth).
German banks and the banks of net exporters (also called competitive economies) are heavily exposed to industry where lending margins are tightest and herefore their cost of borrowing is most critical to banks' profitability and solvency. As those competitive countries could appear so much "stronger" than deficit countries in the politics of the European Sovereign Debt Crisis their cost of borrowing would fall slightly as the deficit countries such as Greece especially found their cost of borrowing soaring. This is a vicious beggar-my-neighbour strategy. And this alone is enough to severely discredit the Euro Project and the prospects of its sustainability.The third paradox is therefore that a Euro system intended to integrate surplus and deficit countries works only when there is growth and appears to fall apart when there is recession! It is failing the essential solvency test that of surviving intact over a whole economic cycle.
With the Euro Sovereign Debt Crisis the European Central Bank that was created to be free of political interference has been displaced spectacularly by the central role in financial structuring taken by leading politicians, by the leaders of the "major powers" in Europe. This is a fourth paradox. It is linked to a sixth paradox that the European Union of equals regardless of size has morphed into a Union where the largest players dictate the economics of the smallest players. This in the case of Greece reminds us of the Munich Agreement of 1938 that dictated the dismemberment of Czechoslovakia without the Czechs at the bargaining table! The European Community, European Union and Eurozone predicated on European integration for the avoidance of war ever again is risking precisely again political disunity and potential for cross-border and civil war violence and possibly military or comparable dictatorships. This is the seventh paradox that financial and trade integration to make war (or near warlike disputes) impossible is now the single biggest factor in Europe's disunity.
In part it is the mindfulness of this that prompts Merkel and Sarkozy and others to seek tighter integration through fiscal unity and more rigid deficit and debt rules. They hope the amrkets are appeased by a rigid common order. But, we have plenty of experience to show us that transparant rigidities in the system encourage aggressive speculation.
It is repeated often that Germany above all fears currency collapse as in 1923. It has a practical fear certainly of a high Deutschmark destroying its trade surplus if the Euro system collapsed and the Eurozone members returned to each having a floating national currency. But, in 1923 the German currency was destroyed by short-selling speculators precisely because it was confined within a rigid system of enforced war reparations payments and dollar shortages. There was no flexibility allowed until it was too late. That the Merkel-Sarkozy proposals and the austerity measures enforced on Greece and Ireland and others are foolishly based on increasing the rigidity of the rules and that takes us further deeply into all the paradoxes above.
Aplying the rules will become even more severe and untenable if the crisis after Austria then more severely engulfs major economies Italy and Spain! The markets will not let up; they cannot so long as the liklihood of worsening crisis persists. It will do so for additional reasons. The Eurozone is in the early period of its normal recession, a recession only to expected that is on schedule to anyway regardless of the Euro Crisis as macro-economists can predict this merely based on past history!
Once Germany cannot politically sustain keeping within the bounds of the Maastricht budget deficit ratio perhaps only then will the Euro system be allowed to become more intelligent and more flexible! The sooner the better for all.It is a political problem of the first order in the wake of the Credit Crunch and Banking Crisis and the various austerity programmes for politicians to be seen advocating any solutions however sensible that sound like "funny money" or "painless" or gaming the system by allowing flexible responses. The mistrust of the voters and their cynicism and anxieties currently are boundless. It will take politicians of truly major statesmanlike stature to explain a truly Communitaire policy response and be believed involving cross-border trust and everyone sharing the blame, burdens, and the rewards according to financial need and not merely according to economic size. A relaxation of the rules and more flexibility in their interpretation plus more sophistication and complexity can supply a relatively painless solution for Europe and the world.

Saturday, 19 November 2011


The Euro Area and the Euro System are in trouble as much from speculative attack by the money markets as from the natural difficulties of getting countries with very different growth stances of a mix of severe surpluses and deficits to share a common currency. It cannot expect all its legs to move at the same time together in the same way and in the same direction, not how any animal system walks or runs.
The EU needs a system of financial rebalancing that recognises the often extreme differences in each state's growth strategy and that accepts the inevitability of economic cycles. The Euro system rules are too simple and too rigid and offer the markets easy targets in the first recession testing of the Euro system.
The current system focuses on GDP only (not GNP) and fails to take account of payments external account and focuses on gross government debt (not net debt).
Greece and Italy are not the same problem except superficially. The EU and Euro Area are inevitably economies with opposing growth settings; export-led such as Germany (with banks focused 60% on lending to industry), deficit-led such as Greece and Spain (banks focused 70% on lending to property), or in rough external account balance such as France and Italy (where bank lending has been too conservative). Ireland is a unique mix of highest trade surplus and equally high payments deficit, which is bizarre? It has the highest trade surplus ratio to GDP and yet similarly high payments deficit. This shows it to be more a regional economy within the Uk than a truly national economy with its own domestic and national financial integrity.
Germany has a trade volume and export surplus equal to that of China. In the EU export surplus countries are equal to two times China. The rest of the bloc has to cope with this. Greece allowed itself to follow the examples of USA, UK, Ireland in growing GDP powerfully based on boom in mortgage lending. The banks were deaf to the entreaties of the Central Bank to stop that and lend more to industry.The central problem is not national debts and who these are owed to. Nor is it that the banks cannot be profitably financially helped by governments over time. It is certainly partly the banks' fault for the dysfunctional pattern within each country of their domestic lending bias. But the politicians are not aware how to address that or that they have the powers through EU laws based on Basel II to do so?
There are technical and definitional problems such as the simplistic Maastricht ratios. These should be termed funny money issues rather than levels of debt, which are well within the EU's financial resources to comfortably cope with over time.
The problem for all Euro Area governments is that when they provide financing loans to their commercial banks they have to do so on-budget and on-balance-sheet because their central banks no longer have treasury bill issuing rights. The USA and UK had no such problems and could insulate taxpayers from the refinancing of the banks.
When member states adopted the Euro it meant that T-bills (debt of 1 year or less maturity) that were previously issuable by central banks now gave up that power to the ECB. Today, countries in the Euro Area only issue T-bills from the Treasuries and debt management agencies and the debt therefore appears on budget (deficit) and on balance sheet (gross national debt). The UK and others can issue T-bills through their central banks where the debt is off-budget and off-balance sheet of the government. This provides immense flexibility to UK and others not in the Euro to provide financing to the banking system without directly embarrassing their budget deficits and national debt levels, a luxury denied to Euro Area governments.IS GERMANY AT FAULT? Merkel has in 2008 and in the years since including this year done and said no other than say Margaret Thatcher would have done and said in the same circumstances. One difference is the quality of Finance Minister and Schauble is not allowing himself to overstep a nationalist line. There is a concern to advertise Germany as safe, successful and superior so that German banks can continue to rely on getting cheapest funding, cheaper than other EU member states' banks. But those banks are heavily over-long on lending to exporting industry that is in severe pain to service its debts. Export surpluses, the principal source of Germany's GDP growth, are not won cheaply! There has come a point in time now when to ratchet down any further on the PIIGS ability to fly will rbound negatively, even catastrophically, on the German economy and the solvency of its banks. If Merkel and her team can see this danger they may start to give more credence publicly to reforms in the Euro system that permit less rigid adherence to simplistic fiscla rules. For the moment, however, the talk is of more rigidity not less and that means rich pickings for financial arbitrageurs and currency shorters, whose pay day is coming soon with the imminence of a full-blown Euro Area recession! Only when Germany has to loosen its own financial constraints it may agree for other member states to do the same? The present disparities will soon result in financial arterio-schlerosis spreading throughout the Euo Area system whereby many more states will find their wholesale finance cost rising and higher funding costs hitting all banks. A bout of recession will markedly worsen this and governments will then have to get together and realise that they have to act in concert and expand their spending and borrowing. Germany's economy appears to be externally strong (large export surplus as the main motor of GDP growth) but internally it is potentially weak. The banks are vulnerable by having loaned too much to industry (which is paying 10% of value added to service bank debt compared to only 10% of profit in case of UK industry, a nearly tenfold difference!).German banks are desperately in need of cheapest wholesale money (to support narrow margins and cash-flow based collateral) hence the hard attitude against deficit countries' fiscal problems - just a way of making Germany look good to wholesale finance providers relatively by comparison. If external trade shrinks and or becomes less profitable to exporters and if the Euro Area breaks up then Germany faces domestic economy meltdown (worst of all if it returns to a strong and soaring Deutschmark). The Euro Area is in any case now into its recession, a recession that follows as it usually always does 2 years after USA/UK recession. (EU/EA's brief recession in 2008 was not the real thing, only a shock from the financial bank crisis).EU politicians have to learn again to kiss their European frog and trust it will turn into a prince again. The USA (Tim Geithner etc.) has very right to criticise the Euro Area politicians for being too reluctant to act in the interest of the whole international community - but he may be foolish to do so publicly. The same may be said of the UK's David Cameron. The Fed, Bank of England and the ECB have a joint responsibility for world money markets and when these seize up they have to intervene jointly. Foreign politician's criticisms - brickbats flung across the Atlantic or across European borders - are usually for domestic political consumption. It is easy to make broad statements but they only make sense when there are concrete ideas to be shared of how best to resolve the problems practically.
It would be a reasonable accusation that the Euro Area fiscal rules are inflexible and simplistic. The Euro had its political supporters but technically was supposed to protect by sheer size against FX-money market speculators. The ECB was set up but placed in a constrained position and consequently fails to sufficiently compensate for the central bank powers that each Euro state gave up to the ECB.
Even the economists internally within the Euro planning teams in Brussels a decade ago foresaw this present disaster. But, back then, they hoped that after the first 5 years new more refined rules and better understanding of the technicalities would have evolved.
This didn't happen for various reasons most of which are political cowardice in face of global FX-money markets - mistakenly believed to be somehow most astute about economics and anyway ultimately all-powerful. The actual dysfunctional nature of information in these markets and their miserable irresponsible short term profit seeking etc. is all beyond the understanding of politicians and even of most political-economists, many of whom get little real-world model-building experience. The bankers also are afraid of economists and refuse to let them into the boardrooms where they fear that economists might take over - preferring instead to deal with the mathematical geeks whose understanding of risk cannot go further than market prices, rating agency ratings, and poorly cultured algorithms.Must a new Euro system be legislated? The default direction of travel here currently among EU politicians is to seek a tighter union and tighter rules with a fiscal policing agency. But, practical reality dictates that the EU and Euro Area need less rigidity not more. The Euro sovereign debt crisis is a product of rigid rules and crude definitions of national debt. It is the rigidity that makes it an easy target for shorting speculators.
The irony of the present situation is that the Euro was constructed to protect all members from money market speculators employing rumor-mongering of exaggerated insolvency scares. It is extremely damaging with incalculable repercussions worldwide in medium and long terms to undermine the credit-standing of OECD countries and to threaten the Euro system to generate investor panic for the sake of short term profits.
Any revised or new system must recognise if some EU members insist on maintaining large export surpluses then others must have sizeable external deficits. They cannot all aspire at the same time to export-led growth.
The Maastricht Rules should be elaborated to be made more intelligent, subtler and harder for the markets to analyse and play merry hell with! It does not follow that the answer is fiscal union or sameness within the Euro Area. And fiscal union should not mean aligning all tax and spending. It is not a sensible or workable basis for justifying cross-border financial guarantees. The proponents of more rigidity and fiscal alignment fail to see this course will require large fiscal transfers evey year between Euro Area member states. President Nicolas Sarkozy called up Hu Jintao recently to ask if China would care to invest in the European Financial Stability Facility (EFSF), the Eur750bn fund. Sarkozy and Kanzler Angela Merkel are imagining China's US$3+ trillion in foreign exhange reserves as a source of ready cash. Should China say yes?
Of course China should participate because it adds to its mystique as a most successful economic power that is impervious to the crisis elsewhere. This is however not the true case. China is extremely vulnerable. Its economy is considerably smaller than official figures suggest and its economy is starting to nosedive beginning with a property collapse. China's banks are teetering on insolvency caused by funding gap and growing poor and non-performing loans and are only sustained by massive deposits from China's foreign currency reserves. China's industry is massively over-borrowed and very vulnerable to fall in export volume and or profits, already accutely modest.
Europe should not seek China's involvement in contributing to Euro Area crisis funds, or from OPEC countries' dollar reserves either. Such a course would be giving foolish testimony to EU insolvency and internal failure, which is not at all the true state of EU or Euro Area financial resources, which exceed that of China plus OPEC many times over!
The reason China cannot loan a few $ trillion is because its reserves are mainly committed by over $4 trillions to supporting China's domestic banks' balance sheets. Chinese households cannot add much to current deposits and are only permitted to borrow a third back while two thirds of household deposits and all of corporate deposits are lent to industry. There is nearly $5 trillion in loans to China's industrial borrowers in support of which the government has deposited $2 trillion with China's commercial banks and loaned them $2.5 trillions Yes, China has extra pocket change (generated annually from the trade surplus) and could support its trade with Europe more assiduously and politically by directly buying Euro Area bonds including those of the EFSF and or IMF, but probably by no more than a % of its annual trade surplus with the EU totalling perhaps $40 billions in 2011. But, this is a trivial and unnecessary, and for Europe's self-confidence and global prestige hugely damaging - EU's politicians need a wake up call to understand the realities they are playing with.
For quite good succinct discussion on the background see:

Wednesday, 20 April 2011

Property lending and rules to save banks from themselves

Millions are frustrated because banks wll not lend them money to buy or develop property. Banks ascribe their lending restrictions to the new "Basel III" capital requirements (effective in 2012). This is not strictly a valid reason. Borrowers and others are given such simple reasons because the total picture is fraught with difficulties in striking the right balance between opposing demands, dogs and fire hydrants, rock and hard place etc. What is going on, or not?
Banks are shrinking their balance sheets and that inevitably means property lending (70% of UK and USA banks' customer loans - after exclusing loans to rest of finance sector which are also shrinking) and also hoping desperately to sell on bundles of property loans and foreclosed properties, if only they can find long term deep pockets to sell to without too steep a discount.
The retreat by banks from property is one reason why insurers and other institutional investors are getting into property lending, seeing an opportunity to do so without competition from banks and expecting higher returns than the banks can achieve.
The bankerspeak financial technicalities.
Basel III changes to higher capital reserves and more core capital of banks (higher amounts and higher loss-absorbing quality) are not genuine reasons for reducing the general loan exposure - it is really about narrowing the funding gap (between deposits & loans) that is filled by selling Medium Term Notes into the "wholesale interbank funding market" and banks are each fearful of when they next have to go to market to replace their MTNs on maturity (big amounts periodically every 3,6, 12, 18 months etc.).
"Internally generated capital" is recovery of monies loaned plus net interest income and other realised profits, and the banks are torn between using those gains to reduce their funding gaps or to increase their capital and liquidity reserves (as regulators under the name of "Basel III" require). They are also torn about how much they can allocate to bonuses rather than dividends. Hence, the banks blame Basel III for lower lending and want everyone to know that as part of their pressure on regulators and governments to soften or postpone Basel III and even on shareholders re. dividends and government and other pref bond holders to expect lower % coupons for longer - when actually it is really about narrowing their exposure to wholesale lenders i.e. to severely reduce their funding gaps, which UK banks have already halved from £1 trillion to £500bn, and falling, and that is a lot of balance sheet liquidated and internal capital generated.
The banks know the wholesale funders well and what is looked for an expected because they are also such funders in terms of their large loan exposures to other financial sector borrowers and have been liquidating cross-border interbank loans dramatically.
When (how soon) a bank has to next replace/refresh its "funding gap" finance will dictate its current openness to agreeing new loans; they are keen to say to their funders here is £5bn matured MTN repaid to you and we only want you to roll-over and buy £2.5bn of new MTNs back from us, which is supposed to sound good to the lenders and there should therefore be minimum fuss or embarassment (narrower spreads) that could leak out to market and damage the share price.
Property (development especially) is seen as riskier, and in addition UK banks are being warned by regulators to reduce the concentration of risk they hold in this one sector (property), especially while they are holding large amounts of receovered property collateral and seeking to sell on about 20% of their property loans (i.e. £260bn), probably with 15% haircuts = £40bn, some % of which could appear as paper loss relative to the outstanding loans, interest & charges that relate to the collateral recovered, perhaps £5-10bn (a wild guess).
The banks are in a bind partly of their own making insofar as the property market (asset prices) cannot recover until new property lending grows and yet until there is recovery they cannot sell their property exposures without risk of substantial loss, and without clearing out of a lot of property they cannot resume property lending.Therefore, if institutional investors (who are the major shareholders in bank other than governments) step in to make up the shortage in new property lending this, if on a large enough scale, could be important to breaking the logjam, and should be profitable to institutions in two ways (for themselves directly and via improved balance sheets of the banks), and given that property conditions are a major aspect of economic growth recovery.
But, when property lending is resumed by banks more assiduously the first port of call may be to refinance troubled loans rather than agree new loans to new borrowers, that is long term loans especially, while short term lending only looks relatively attractive to many banks. Medium to long term lending appears to have too many uncertainties i.e. the risks are very hard for them to compute.
The wider context includes policy that is torn between being seen to put in place measures that can be claimed to make sure the credit crunch recession never re-occurs, while also needing bank lending to stop shrinking and then to grow to generate more certainty of substantially higher economic growth. This facing in contradictory directions is why there is much fudging about the impoact of Basel III regulation including the Vickers Commmission recommendations that many outside UK as well as in UK hoped would provide a clear new line to follow and refresh the impetus of the G20 agenda of about 100 adjustments, policies and new institutions to protect the financial system from itself.
So-called "Basel III" rulings aim to increase banks’ tier 1 capital base from 2% to 4.5% (ratio to gross loans, or twice this to risk adjusted loans) to improve the resilience of banks. These discourage securitisation transactions, and there are four ways banks can increase their capital base to meet new ratios: raise more long term capital themselves (internally generated by cutting costs, bonuses, dividends and coupons), raise more in deposits, shrink loan balance sheets, commit less own capital to investment banking (market trading & derivatives), and reduce exposure (in economies where property dominates) to property and property loans.
There is the hope that interbank lending and funding gap finance and securitisation of loanbooks will sooner than later return as a reliable and substantial option, but only once the banks look safer bets i.e. the banks are strong enough to again dictate the loan spreads to those they borrow from. That is unlikely so long as the sovereign debt crisis reflects badly on banks and so long as Basel III looks hard for banks to comply with, even if these are very much parts of the banks own PR to shift the blame (playing up the sovereign debt crisis) and to soften new capital rules (foot-dragging on Basel III).
From the point of view of individual borrowers going to the banks with wonderful schemes of great quality all this bigger picture about future impacts reasons given for refusing loans is an immense frustration. It is actually the excat inverse of the pre-credit crunch past when banks ignored the bigger macro-economic and regulatory picture and approved any loans that passed merely microeconomic tests based on past high growth experience and not on forecasting future downturns. Yet, while the medium term future should be one of renewed growth and recovery, Basel III is ensuring future risks are assessed in terms of possible repeat of economic down turn (double-dip or another recession)!
In the case of seeking loans from banks that are underwritten or otherwise backed by government should ensure that banks can lend comfortably because the risk is low. But, low risk also means low net interest income when banks are anxious to raise their % net interest income, and given uncertainties about even government finance (subject to unexpected renewed cost-cutting at budget time) state-support may not of itself be sufficient to get the banks to lend. Institutional investors seeking to fill the gap also may not be attracted sufficiently by the low margins despite state guarantees. They are attracted by commercial property, not residential, and are not stepping into property lending because they are attracted by low margins of bank lending. Insurers are attracted by the higher interest income generated by commercial property loans compared with government bonds.
Over half a £/€trillion in commercial property loans are maturing in C.Europe over next 3 years and possibly a third of that additionally in the UK. Institutional investors will step in where banks fail to roll over what is of good quality and cannot be all repaid, and are already now financing about one quarter of comemrcial property lending.