Now that some sort of Greek bailout is imminent, most likely in asset guarantee form, it is high time to evaluate the full impact of Europe's decision to jettison monetary prudence at the expense of patching a crumbling fiscal dam holding back trillions in bad investment decision cockroaches, accumulated over the years. Relying on a presentation by ML's Jeffrey Rosenberg1, we observe that by providing loan guarantees to the periphery, the core (Germany/France/Benelux) may have well destabilized the core problem for the Eurozone, namely a whopping €1.6 trillion (that's in euro) in total 2010 financing needs, a number which consists of €400 billion in 2010 bond maturities, €700 billion in rolling short term debt and €530 billion in combined 2010 fiscal deficits. Germany has just taken an acute liquidity crisis in the periphery, and courtesy of action we already saw earlier in Bund rates, has sown the seeds for a funding crisis of none other than the very heart of the Eurozone.
First, in evaluating the fundamentals of the various "advanced economies" that make up the EU, we notice that shifting fiscal exposure to be in compliance with the G-20 requirement to have 60% or lower debt to GDP ratios by 2030, would require a "shift in the structural primary balance from a deficit of 3.5% of GDP in 2010 to a surplus of 4.5% of GDP in 2020 and keeping it there till 2030." As we have seen in our own recent budget projections, America will certainly not be able to turn a deficit to any palatable surplus at any point over the next 10 years. We find it extremely unrealistic that Europe will succeed where America's financial wizards have failed.
What Germany has done is merely to buy some time and moderate the near-term "solvency" crisis in the PIIGS, while exacerbating the true fiscal weakness underlying the European economy. Paraphrasing Merrill: "In the current episode, the focus of risk among Greece, Portugal, Spain and other peripheral members of the Eurozone is not a currency crisis. With their debt denominated in Euros, this crisis is a long term “solvency” crisis precipitating a short term liquidity crisis. Hence, the short term solution lies in addressing the liquidity crisis."
In essence, the ECB is merely providing the tried and true band aid approach made legendary by the Hank Paulson, Ben Bernanke and Larry Summers trio.
"[The table above highlights] that: 1) the issues facing the periphery of the Eurozone are by no means limited to these countries; 2) that in total the Eurozone structural deficits even if absorbed into the total Eurozone result in a lower degree of strain than either the US or the UK; and 3) sovereign risk over the longer run will not be limited to the periphery of Europe. the problems of the periphery countries could be easily absorbed by the Eurozone, such a choice would not come without consequences."
Indeed, according to official estimates, over the next 5 years the economic situation as quantified by Debt/GDP ratios is expected to deteriorated dramatically.
And this is all occurring on the backdrop of a proposed $1.6 trillion 2010 and $1.3 trillion 2011 budget for the US. Just who will come out, guns blazing and buy these tens of trillions of debt needed to finance what is rapidly becoming a global moral hazard liquidity crisis?
In quantifying the amount of "moderation" (read, cold hard cash either in direct funding form or via guarantees) needed to remove the liquidity crisis overhang, it is first necessary to evaluate the total upcoming debt maturities, and not just for Greece but for all the eurozone countries: keep in mind, moral hazard is now a pan-European phenomenon.
The table below summarizes the monthly scheduled maturities for the bulk of the Eurozone.
Yet the immediate test, as expected, is once again focused on the PIIGS (or GIPSI if one is so inclined) acronym: it is not surprising that a decision came out today - after all there is an auction scheduled for Portugal just tomorrow, while Italy will test the market with a €6-8 billion auction this Friday. Absent today's (dis)information campaign, the Portuguese auction would have certainly been another failure. Yet by and far the country with biggest near-term risk is Spain, which will need to finance €30 billion in February. Subsequently, critical auctions follow in Portugal for €3.9 billion in March and in Greece for €12.4 billion in April.
But why stop here: now that all European debt will be brought to the lowest common denominator, namely the demand for German securities, which is at the heart of the backstop plan, it implies that global European funding requirements have to be evaluated in total, and not piecemeal as we did until today. When compiling this data, we attain a shocker: the Eurozone will need to finance, roll and fund deficits to the tune of €1.6 trillion in 2010 alone. Keep in mind that the U.S. faces a very similar situation, as it has to fund roughly $1.7 trillion in net issuance in this calendar year, and prior analyses indicate that there will likely be a $700 billion shortfall absent a dramatic upswing in rates. What this means for Bund rates... is not all that complicated.
It is sheer lunacy if the ECB and Germany believe that the guarantee program will not wreak havoc on their plans to quietly fund this massive hole. And there is more. Merrill notes:
The greatest near term risk is a policy error. One likely candidate is attacking the symptoms of the crisis rather than the causes. Banning short selling during the financial crisis had little impact in stemming the declines, and similar calls may emerge in the current sovereign risk scenario. As in the financial crisis, policy interventions do not come without cost. The moral hazard of supporting poorly disciplined government finances only encourages bad performance in others. But the alternative likely will be a greater and uncertain outcome. Near term, we expect further weakness in periphery sovereign debt spreads to German benchmarks, further weakness in the Euro and continued headline risk out of the sovereign risk story before ultimately these accelerating liquidity concerns and rising debt refinancing costs prompt a greater policy intervention to arrest the liquidity crisis. That will buy time for governments to address their long term solvency crises ultimately behind the current sovereign risk uncertainty.
As always, extend and pretend, while not one economist or politician has provided any answer to the real question that needs addressing: how will marginal treasury revenue, be it in Greece, in the EU, or in the US, increase in light of massive and neverending end-consumer deleveraging, and a bubble that is set to pop in China, taking away trillions in virtually free capital with it. Today the crisis just went global, yet we bought ourselves another 6 months of imaginary time in which the surface will be calm but ever greater disconnects between valuations and fiscal realities, not to mention monetary distortions, will develop, ultimately all resulting in an unraveling on a historic scale.
The conclusion is that Europe just took a sharp and dramatic turn for the worse (which, however, was in many ways unavoidable). Yet instead of going the American route of pretending that things will get better if just ignored for long enough, Europe had the option of determining its own fate and doing the right thing - which would have been to take the bitter pill of acknowledging the EMU failure, cutting weak peripheral countries loose and focusing on a new, solid European core, and not so much competing with the US in attempting to recreate a melting pot experiment of numerous completely non-compatible cultures and norms.
Below we present some pretty BAC charts which show how comparable liquidity crises played out in the past.
- 1. In for a penny, in for a pound (or a Euro), February 8, 2010