Tuesday, November 23, 2010


In a note to clients this morning Credit Suisse downplayed the severity of the crisis in Europe and explained why they believe it is contained.? Specifically they said:

“We continue to believe that this is not a systemic crisis for 3 reasons:

(1) The total cost of a worst-case write-off in the Ireland, Greece and Portugal is €170bn, on our calculations (this is based on the cost of severe emerging market banking crises in the past, which has been 30% of GDP, compared to write-offs amounting to 8% of GDP in the European periphery so far). Against this, the amount of money available is around €670bn (€250bn EFSF post haircuts, €60bn from EU, €250bn from the IMF, €110bn from Greece).”

So, clearly these smaller nations are merely the appetizer.? They are too small to threaten the EFSF’s ability to “work”.? But the math is not friendly once we move onto Spain and Italy.

“(2) Core Europe cannot afford to turn its back on peripheral Europe. The direct cost of doing so would be at least $500bn, because the ECB now owns €63bn of peripheral European bonds directly and nearly €320bn indirectly via repos, with two thirds of the cost of any ECB recapitalization falling to core Europe. Furthermore, core Europe has nearly $900bn of banking assets in peripheral Europe. The indirect costs of a failure of the monetary union would be even greater, namely the loss of a single market, with the newly established Deutsche Mark likely to appreciate by 20%, hitting German exports, the probable erection of trade barriers etc.”

As I’ve long maintained, there is simply too much political will invested in the Euro’s success for it to be allowed to unravel completely.? They are fully invested in the Euro’s continued existence even though it is now proven to be a failing project. CS says the 800 pound gorilla (Spain) is sustainable for now:

(3) The situation in Spain is sustainable for now. This is critical because there is nearly €460bn of core European bank assets in Spain and Spain accounts for 11.5% of European GDP (70% larger than Portugal, Ireland and Greece together). The reasons the situation in Spain looks sustainable is that: on current bond yields, interest payments are 3.7% of GDP (if all of debt is funded at the long end), compared to 6.7%, 7.4% and 16.7% in Portugal, Ireland and Greece – and, critically, they are below the long-term nominal GDP growth rate. Spain looks sustainable until bond yields rise to 6.5% from 4.7% currently.

Even if we assume that ultimately the government has to take on a third of Spain’s excess private sector leverage (on our calculation the resultant deleveraging needs to be 60%-90% of GDP-looking at the private sector deleveraging that has occurred after previous emerging market banking crisis), Spain’s government debt to GDP ratio would end up at 85%, from 64% currently. This would still leave funding at sustainable levels (interest payments as a proportion of GDP would still be 4%, even if all the funding was done at the long end).

Furthermore, we note that:
- Spain has had no fiscal slippage for the current year and is set to hit the deficit target of 9.3% of GDP;
- Spain is unlikely to hold general elections until 2012, making the political situation more stable than in, say, Ireland;

- Borrowing from the ECB by the Spanish financial sector has fallen by nearly 60% since June.

There’s a huge “if” in all of this.? If an analyst had written this commentary regarding Ireland in 2009 they likely would have come to the same conclusion – as long as yields remain at reasonable levels the country should have no problem funding itself.? Of course, that all changes when the bond vigilantes show up at your doorstep, and yes, there most certainly are bond vigilantes in Europe.

(Irish 10 year bond yield)

Portugal is certainly next in line for aid here.? As Danske Bank recently stated the probability of aid requirement in Portugal is “very high”:

“If Ireland seeks help (Scenario B) we expect Portugal to follow, either immediately or following a short period of market tension. The answer to everyone’s question – “who is next” – is without doubt “Portugal”. Therefore, everyone may find themselves running for the door (once again) if Portugal tries to avoid this fate. In that case it will eventually have to follow. Portugal has already faced two rehearsals so they are likely to have learnt their lesson and try to end the pain sooner rather than later. The biggest risk is that the debt crisis will spread to Spain and Italy.”

Credit Suisse agrees with this analysis:

“Portugal is in a better position than Greece and Ireland – but we still think the situation is unsustainable. First, Portugal has a current account deficit of 9% of GDP (this shows its huge loss of competitiveness and its need for even more acute deflation and de-regulation than elsewhere in peripheral Europe). Second, on current bond yields, interest payments would be nearly 7% of GDP, 2.5% above long-term trend growth. This means, it would require cyclically adjusted fiscal tightening of around 5% of GDP to stabilise government debt to GDP. Private sector credit to GDP is 171% (the best fit line suggests that it should be close to 110%). The reason why Portugal is in better shape than Ireland and Greece is that: a) the cyclically adjusted budget deficit is 3% of GDP. Without any cyclical adjustment, the budget deficit is 7.5% of GDP in Portugal versus 9.4% of GDP in Greece and 12% of GDP in Ireland (excluding the cost of bank recapitalizations for this year); b) the economy has actually managed to grow over the past three quarters; and c) private sector excess leverage is less extreme than in Ireland. We would advise clients not to bottom fish in Portugal.”

Bond yields in Portugal are already surging and credit markets? are not only honing in on Portugal, but already looking past Portugal at Spain.

(Portuguese 10 year bond yield)

(11/22/10 CDS Wideners)

JP Morgan noted the other day that some tensions are already reappearing in the Spanish banking system:

“The most recent issues and debt exchanges came with a heavy premium relative to secondary market levels, suggesting that it is becoming harder and more costly for Spanish banks to refinance their debt. In Caja Madrid’s debt exchange this week, covered bonds were priced at 250bp above mid swaps. CajaMar’s covered bond issued at the beginning of the month was priced at 290bp over mid swaps. These levels are close to the wides of the summer…”

So, in essence, we have all eyes on Spain.? If Spain is forced to tap the EFSF markets will start getting very panicky.? Back in May I described why the EFSF would likely fail.? The EFSF was never really intended to handle Spain in the first place.? It was in essence, a gamble that the very existence of such a fund would ease tensions across the region and buy some time, but Europe is running out of time.? This remains a currency crisis in which a solvency crisis is merely a symptom.? At the end of the day single currency systems simply don’t work in the best interests of all involved.? It is the primary reason why the gold standard failed and it is the reason why pegged currencies create distortions and disequilibrium in markets (just look at the bickering between the USA and China).

Sadly, I think the Europeans are so heavily invested in the Euro that they have no choice but to kick the can and see that it continues to exist in some form of its current self.? That likely means many more years of depression in many countries and ultimately some real reform that at least partially fixes the structural flaws in the EMU.? Full unity, a United States of Europe is simply not realistic in my opinion.? That likely means the core will be forced to fund the periphery until one of two things happen:

  • The periphery nations revolt and realize that they are suffering at the hands of foreign bankers and an inherently flawed currency system.? OR;
  • The core realizes that they are going to be forced to fund the periphery deficits for years to come.

In the end, this all leads to one road – defaults (or restructurings of some kind) and/or defections.? The Euro is a flawed single currency system.? Even if we get extremely lucky and survive this crisis without any serious repercussions the likelihood of future problems are 100%.? This is simply what single currency systems do.? They put particular trade deficit nations at risk of severe financial constraints.? The inability to properly deal with these problems has always led to major reform, abandonment, default, revolt or war.? Let’s hope we can avoid the last one.


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