Trump And Draghi May Bring A Return Of The "European Solvency Crisis": Barclays

Tyler Durden's picture

Since Drahi's infamous "whatever it takes" warning in the summer of 2012, European bond yields have been a one way street lower, and until the recent Trumpflation rally, had tumbled to all time lows, in many cases well below 0%.  There are two catalysts, however, that may be ending Europe's QE-driven free ride, and according to a recent report by Barclays, their names are Donald Trump and Mario Draghi.

First, when looking at the impact of Trump, Barclays notes that his election as US president may have created an additional burden on European budgets: defence spending.

The president-elect has suggested that European NATO members should reach the 2% GDP military spending target, as pledged under the NATO treaty. In 2015, the 22 EU countries that are also NATO members spent on average only 1.4% of GDP on defence, or 1.3% excluding the UK, while the US spent 3.6%. This is a shortfall of USD94bn, or 0.7% of the total GDP of EU-NATO members.

Those countries whose debt to GDP ratios already exceed 100% (Italy, Spain and Portugal) are also the ones with low defence spending and would need to add 0.7-1.1% of GDP in defence spending if they were to reach the 2% target as shown in the figure below.

In Trump carried out his threat and enforced a mandatory topping of contributions, and Italy had to boost its annual defence spending permanently to 2% of GDP (all else equal), its primary surplus would more than halve, from 1.7% currently to 0.7% of GDP. For France, Fillon and Juppe are arguing to increase military spending progressively to 2% of GDP by 2025, while they do not envisage any significant change in stance towards NATO.

It's not just Trump's NATO policies: there is also the impact of the ECB's QE which sooner or later will be tapered off. That, however, will result in the tide going out, and exposing just how naked Europe's economies have been all along.

As Barclays also writes, "the ECB‘s QE has been an important driver of EA growth and public debt dynamics, but at the cost of moral hazard."

 Barclays finds that QE-generated growth, more so than low interest rates, has significantly contributed to a slowdown in the rise of the public debt, particularly in Italy and Spain. As shown in Figure 2, public debt would have risen an alarming 12% in these countries without QE.

The British bank's analysis also suggests that those countries with the most significant bond market pressure also pursued the most reforms. But rather than using the temporary relief created by QE to reform and repay public debt, fiscal policy in Italy and Spain became expansionary and reforms ground to a halt. In other words, as we warned all along, all QE does is kick the ball into the ECB's court, while giving lazy, incompetent politicians the justification to do, well, nothing - certainly nothing that may threaten their careers - and simply watch as the stock maret rises, giving the false impression that "things are good."

Debt sustainability issues will likely therefore resurface not only due to higher interest but also, critically, because long-term growth prospects are poor without reforms, and it is now entirely recognized that it was the ECB's fault why Europe's nations - all badly in need of structural reform - abandoned all such efforts; after all why bother when "Mr. Chairman will get to work."

Here are Barclay's details on why solvency concerns will re-emerge for Europe the moment Draghi even whispers a hint that QE is about to get tapered, let along end:

With funding costs at historical lows and QE expected to remain in place for the foreseeable future, few investors are worrying about the long-term sovereign solvency of the euro area. But this could change. Draghi reminded us of the obvious in September, namely that “QE is not forever”. When the tide turns, many euro area sovereigns may very well be confronted with higher “r-g”, not only because of higher r (as monetary policy tightens) but, critically, because of low g, as long-term growth prospects are dismal without reforms.

 

Compounding the problem of sensitivity to the assumptions (for r and g) is the issue of interdependence across variables. Primary balances and fiscal stances in general affect both interest rates and growth rates while growth rates affect the fiscal performance. If it is indeed the case that low interest rates – supported by ultra-accommodative monetary policy – delays necessary fiscal consolidation and supply-side reforms, arguably low r means low future g. Growth plays a critical role into debt dynamics through direct and indirect effects: the largest public debt contribution of QE came from the growth channel. If our assessment is correct, and governments fail to raise the long-run growth rates of their economies owing to complacency, it is plausible that the European economy will remain stuck in a low-growth equilibrium, where permanent QE is required to keep funding costs down, which coincidentally leads to delay in important reforms.

There is another problem, in fact the biggest problem of all from day one: massive debt loads, which were never reduced in the aftermath of the great financial crisis, and which need soaring prices to be reflated away, however in the process of rising rates, those same debt balances effectively assures a financial crisis. Quote Barclays:

The political landscape across the euro area argues against very high primary balances; in fact, we have seen how the primary balance has recently worsened and fiscal accommodation has increased. For Italy, public debt is currently at 134% of GDP, the primary balance at 1.5% of GDP, nominal r is at c. 3.2% and g is c. 1.5% (i.e., r-g = 1.7%). A small increase of r-g to say 2 or 2.5% would put debt/GDP along a rapidly growing path.

 

In theory high debts do not necessarily imply a sovereign crisis, especially if the government spends its money wisely and collects taxes efficiently. But if it does not, solvency concerns could re-emerge, sovereign interest rates quickly rise above the average funding costs, and the 2010-11 adverse market dynamics could return. The big difference is that this time there would be far less monetary, fiscal, and political space to confront them.

Two conclusions: i) as Barclays puts it, "the great fiscal success of QE could therefore turn out to be its biggest downfall in due course" and ii) everything that has happened since Draghi's infamous "whatever it takes" gambit nearly 5 years ago, has been one great can-kicking detour, and the moment he market even gets a whiff that Draghi will punt on record QE, Europe's crisis is back with a bang.

On, and there is the whole "Trump" wildcard, not only as a result the wildcards from his NATO funding policies, but also because should the global reflation scare accelerate, then the ECB may have no choice but to tighten/taper/end QE sooner than anticipated as inflation worries spread to Europe, which in turn will catalyze the next leg of the Europea solvency crisis, which is inevitable as Europe failed miserably to engage in reform in the five years since Draghi's words pushed European interest rates to all time lows.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Elco the Constitutionalist's picture
Elco the Constitutionalist (not verified) Nov 27, 2016 9:04 PM

It all crashes at once, or not at all. I hope they can keep the ponzi running for another 60 years. Then again, they might have to kill us all to achieve that. Or at least enslave us.

Money is irrelevant. It is he who controls the "printing press" that matters now.

Usury is an extremely unstable economic system.

Kassandra's picture

Technically, we're already enslaved...

But the reality is, at this point in time..I just don't give a shit.

BabaLooey's picture

The EU will implode because of ..............

The EU ITSELF.

Trump is like them watching from the sidelines, what will happen to them.

LePen

ELExit

Itexit

LaPOOF

David Wooten's picture

Some time in the next year or two, a world-wide currency and debt crisis will require a monetary reset that will ultimately devalue all the world's currencies and probably bring about a new reserve currency.

Yen Cross's picture

 Pull those blinders back... It's already happening.

wisehiney's picture

Oh shit.

Better run back to the safety of treasuries.

tarabel's picture

 

 

When Bretton Woods and NATO were firmly ensconced, it was very difficult for any economy that mattered to gain an advantage over the rest of the pack by backsliding on their joint responsibilites or by playing currency games.

It is time and high time for an American leader to insist that the game of letting Uncle Sam shoulder an extra defense burden while everyone else lolls about comes to an end. It really isn't any different from paying your electric bill. After a short period of indulgence for slackers who prefer to spend thier money on beer and pizza, the power company kicks them out into the darkness until they, shall we say, see the light.

lasvegaspersona's picture

There is a problem with your analysis. The US can just borrow and spend ...'withpout the pain of work' as DeGaule put it. The rest of the world supports that system by holding that massive pool of dollars calling them 'reserves'. If all those 'reserves' were to suddenly become 'spending money' the dollar would not last through a single session. 8 trillion suddenly flowing through the Forex markets and a burger would be...unobtainable with dollars.

ZH Snob's picture

all they do is hide the sausage.  first here, then there, back and forth until we're not really sure if there ever was a sausage to begin with.  

xythras's picture
xythras (not verified) ZH Snob Nov 28, 2016 12:17 AM

At this point I'm pretty sure there's a sausage up Draghi's butt.

And by the look of it it might be a very spicey one.

buzzsaw99's picture

barclays could have saved a bunch of cyber ink and just wrote: there is no market, there is only the ecb.

Felix da Kat's picture

Barclays is strictly pro-globalist, so naturally they disdain any political force that is its contrary. Barclays is one of a few dozen international players that root hard for the failure of nationalism (Trump, Farage, Le Pen, et al...). The future growth of such multi-national banks is almost entirely dependent upon an intertwined global network; without it, they stagnate and wither. The era of ever-larger international banking empires has passed. 

lasvegaspersona's picture

It was 'Bushes fault' for 8 years AFTER he was out of office...now it is Trumps's fault and he isn't even in office yet.

Maybe the Dems will start blaming the 2020 candidates too....they are 'scary'...and upseting the markets...

ecrtr's picture

How can Barclays write an article titled, "Trump and Draghi may bring a return of the 'European Solvency Crisis'". Is this the fake news from Russia that all of the media outlets are talking about? I personally believe that the Donald could make any crisis he wants without the help of Draghi.

hedgiex's picture

In the long run if you survive the climate changes, EC is a toast. Keep your long dated puts on and roll them forward at each maturity. This should include the spinners like Barclays. 

billhicks's picture

Read your first sentence and thought muppet.
Read your second and third sentences and thought he knows.
Well done.
Ps if your first sentence wasn't a post truthian side swipe let me give u another red pill. Climate change is as fake as the economy. Yeah it's always changed. It's the sun stupid. Just like it's the fake economy stupid. Also it's not EC it's EU. But yeah you're doing ok.