SERIOUS MONEY: EUROPE'S TECHNOCRATS announced to the world in September that they had just "six weeks to save the euro". The disturbing rhetoric was duly followed by the 14th summit in less than two years and the third comprehensive attempt this year alone to quell the rumbling debt crisis that continues to question the viability of the region's monetary union.
The proposals agreed to at what was dubbed the, “summit to end all summits” were received enthusiastically by financial markets but the initial euphoria was dashed by subsequent events in Greece that can only be described as farcical.
Athenian comedy aside, credit markets have had ample time to deliver their verdict and the message emitted by debt investors is far from encouraging. Perhaps this motley crew understands that the procyclical nature of the agreed measures threatens to push the region’s economy ever closer to a deflationary abyss – absent sufficient and necessary support from the European Central Bank.
European leadership finally bowed to the obvious and admitted that the sovereign debt crisis had degenerated into a banking crisis and, as a result, accepted that the financial sector is in need of recapitalisation. The news came just weeks after the new IMF chief, Christine Lagarde, was dismissed for daring to speak the truth, as the technocrats continued to insist the banking sector was not short of capital.
The dramatic turnaround now sees officialdom accept, albeit belatedly, that the banking sector is indeed undercapitalised to the tune of €108 billion and, has given the banks until the middle of next year to bring the ratio of capital-to-risk assets up to 9 per cent. Although the development is welcome, the proposal could have several negative unintended consequences.
First, the official estimate of little more than €100 billion is unlikely to ease the stress on bank funding costs for long. The number falls well short of independent estimates that range from €200 to €400 billion, which is hardly surprising, given that the stress tests focus only on a Greek debt restructuring and, do not cater for an economic downturn that may well be in progress already. Thus, the amount of the recapitalisation is unlikely to reassure investors, since it does not reflect the sector’s ability to absorb the losses arising from an adverse scenario.
Second, the decision to mark down all sovereign debt-to-market values based on prices on September 30th, is likely to place a floor on yields, since lower levels would almost certainly lead to an avalanche of bank selling. Furthermore, the negative impact on bond yields is likely to be compounded by the supposed “voluntary” nature of the haircuts pertaining to the private sector holdings of Greek debt.
The fact that the large writedown on such debt is not deemed to be a negative credit event means that the market for insurance against sovereign default doesn’t really exist and, as a result, the yields on the debt of other struggling sovereigns is likely to trade higher than would otherwise be the case.
Third, it is unlikely that all banks will be able to meet the requirements via new security issuance, reduced dividend payments and share repurchases or from other cost-cutting measures. Thus, at least some of the additional capital is likely to come from government, which would put further strain on already stretched public sector balance sheets and, could precipitate a fresh round of rating downgrades.
Fourth, the evidence from Japan in the late-1990s and in the US at the height of the financial crisis, suggests that the plans to recapitalise the banking sector could precipitate a credit crunch and a nasty recession if sufficient monetary easing is not provided by the ECB.
It is virtually inevitable that the banking sector will attempt to meet the capital requirements through asset shrinkage rather than the sale of securities at distressed prices. Restricting the availability of credit will push the private sector’s surplus higher and exert downward pressure on both consumption and investment, just as the public sector is engaging in fiscal consolidation and attempting to push its deficit lower.
A painful recession could well be the result unless exports absorbed the adjustment. This is unlikely to happen, however, as the rest of the world is hardly reporting robust growth numbers. Thus, the adjustment is far more likely to be reflected in reduced imports rather than increased exports and, given that more than one-fifth of US exports are shipped to Europe and the region is China’s largest trading partner, this is the mechanism through which a euro zone recession is likely to be transmitted to the rest of the world.
The “summit to end all summits” a fortnight ago proposed a number of far-reaching measures intended to underpin financial stability in the euro zone. However, the procyclical nature of the proposals including a bank recapitalisation plan, threatens to push Europe ever closer to a deflationary abyss. It’s time for the ECB to step up to the plate and employ its balance sheet.
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