In Order To Be Saved, Spain And Italy Must First Be Destroyed
There has been much confusion over last week's remarks by Mario Draghi, with the prevailing narrative being that the market first got what Draghi meant wrong (when it plunged), then right (when it soared). The confusion is further granulated by attempts to explain what was merely a desperate attempt at delaying a decision for action, which was inevitable considering the now open opposition by Buba's Weidmann, into a formal and planned plotline: "Inverse Twist" or other such technical jargon is what we have seen floating around. The reality is that, just like all other central bankers, Draghi did what he does best: use big words and threats of action in hope it will buy him a few extra days of time. The reality is also that, just like when the LTRO was announced, the market did get it right initially, when peripheral bonds plunged, and got it wrong over the subsequent 3 months when bond prices rose, only to collapse to new lows (and in the case of Spain - record high yields as of two weeks ago). Back then, the ECB merely bought a few months time with its transitory intervention. This time it has at best bought a few days with the lack of any actual action. And yet, Draghi did leave a way out, for at least another brief respite (where unless Europe expands the available bailout machinery yet again, the respite will have an even briefer half life than that from the LTROs). The way out is simple, and in order to avoid any confusion, we will use an allegory from the movie Batman: Spain and Italy can be saved. But first they must be destroyed.
Why? Because the market may or may note have gotten the desired knee jerk response right - higher - eventually, but what it got absolutely wrong is the fact that in the new normal, attempts to front-run politicians, whose motivations are entirely different from those of the market, are always and without fail self-defeating. In other words, by sending the Spanish and Italian curve short-ends soaring (and yields tumbling), the market just made the only catalyst that would validate the kind of response to Draghi's comment that we witnessed in a few short trading hours, meaningless.
We have already explained why on numerous occasions, so instead we will hand it over to Citi's head Euroearea economist Jurgen Michels, who explains it so simply, even a caveman vacuum tube can get it:
In order to activate the ECB’s new facility, Spain and Italy have to ask the EFSF for assistance, and the Eurogroup (backed by the German parliament) has to approve the request....Mr. Draghi was very explicit in respect to the conditions for ECB assistance for governments in bond markets, but Spanish PM Mariano Rajoy and Italian PM Mario Monti ignored that part of the ECB statement.
While Mr. Monti, as before, left open whether Italy would requeEFSF/ESM assistance, Mr. Rajoy, also in line with previous statements, declined tostate that Spain would ask for such assistance.
To us, this is another example of the Spanish government’s poor communication, and highlights the need to restore credibility by getting external monitoring (at least from the EU Commission and the ECB, probably with technical assistance from the IMF). Given the strong resistance of the Spanish government to asking the EFSF/ESM to activate the primary market purchase facility — although a Memorandum of Understanding regarding the required conditionality is already available with the existing bank support programme — and with no planned issuance in coming weeks, we do not expect that Spain will ask for assistance in August.
Forced by a further increase in its funding costs, we expect the Spanish government to make a U-turn and to ask for assistance during September.
And what is true for Spain, is true for its far bigger, and just as financially distressed cousin, Italy.
Therein lies the rub: by pushing the funding costs on the short-end far cheaper, both Rajoy and Monti are now certain to not even consider asking for a bailout - after all the market just validated their failed policies (or so they think)! To the career politician and unappointed technocrat, instead of having to ask for aid, the market's response is one which precludes said aid request... Until, at least such time as the market realizes it was once again manipulated by politicians.
What happens then is the same rinse-repeat cycle we have grown to hate and loathe so well: the Spanish and Italian curves go bidless, in the process inverting once again, followed by the same summit/ECB announcement response with promises that both Spain and Italy will demand a bailout, sending bonds soaring, and making a bailout demand unnecessary.
Of course, this Catch 22 of confounding cause and event can continue seemingly indefinitely, although in reality it can't. Because fundamentally what the bond market does is keep sovereigns "honest" - just as Schauble said a week ago, Spanish yields at 7% are not the end of the world - instead what they are is a signal to the country to get its spending in control in order to reduce its deficit, and fundamentally get its house in order - yes, that means getting government spending to a sustainable level and firing hundreds of thousands of workers, as well as probably raising taxes even more. It also means pain all around, but the pain is inevitable and will only be worse the longer reality is denied.
Thus all the ECB does, with every incremental attempt to manipulate the bond curve, is delay the day when the inevitable hard choices and difficult decisions have to be made. In the process, the deficit gets bigger and bigger, even as the country can still continue to fund itself at seemingly sustainable rates (very soon both Italy and Spain will be forced to keep rolling its debt every several months as anything beyond Bills will be trading at ridiculous rates, while the short-end will be anchored by fears of more brutal Draghi rhetoric). All this comes to a head eventually when the spread between reality and central bank ivory towers becomes so wide not even the most Stockholm Syndrome-addled bond "vigilantes" can continue to ignore it any longer.
As noted previously, there is a simple loophole: both Spain and Italy request a formal bailout, i.e. Gotham Burns. Here is how Citi views this outcome:
"In order to make it politically digestible, the request for EFSF/ESM aid might come together with a cabinet re-shuffle."
Here we completely disagree - the issue is that by formally admitting failure, it means the end for the current administrations, and a career end of many politicians, for whom preserving their jobs is a matter of survival. It also means civil unrest and disobedience, as it means the ascent of the Troika (and implicitly Germany) to the highest level of government control; what it means to the local citizens is one simple thing: relinquishing sovereign control to an external presence. For those who are unfamiliar with European history, the best laid plans which have as their weakest link the assumption that any proud people will willingly cede to foreign control, always are doomed to failure.
Yet this is precisely what the bond market assumed when it sent Spanish and Italian bond yields plunging in the past week.
We give what is left of the market a few more days before the delayed correct re-reaction once again establishes itself, and the push for a formal bailout leads to curve inversion all over again, only this time more jawboning will not be enough, and neither will be Draghi's solemn invocation to "believe him." That bridge has now been burned.
* * *
Finally it is not just the above logic that leads us to this belief. The previously mentioned Jurgen Michels from Citi lays out all the other "weakest links" in what Draghi may or may not have said.
Below we present Michels' latest musings on why, much to the chagrin of all those who are long peripheral bonds on hope and prayer, the market's initial selloff reaction to the Draghi statement was in fact the correct one.
Uncertainty about ECB Measures and Activation of EFSF/ESM Support Mechanism
ECB Council supports Draghi’s statement on irreversibility of the euro...
By saying that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough,” in his speech in London on July 261, Mario Draghi created a big market rally and puzzled many observers, including us, about the reasons for that speech. In the ECB press conference, he said that he deliberately used the strong wording to highlight the irreversibility of the euro and added that “there was not one word [in the London speech] that has not been discussed with the Council before”. While not using the same strong language as in Draghi’s London speech, the unanimously supported ECB August statement says “Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible.”
…but Bundesbank is against the extension of bond purchases, even conditional ones
Predictably Bundesbank President Jens Weidmann opposed the Governing Council statement that “The adherence of governments to their commitments and the fulfillment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures.” In the Q&A session President Draghi explicitly said that governments have to go to the EFSF/ESM first (necessary condition) before the ECB would consider using the new facility, but stressed that being under an EFSF/ESM programme is not sufficient (ECB independence).
ECB managed to find a face-saving way to continue sovereign bond purchases
With this kind of conditionality the ECB found a face-saving way to continue its support. After setting up the SMP in May 2010, the ECB used it as a bridge to support bond markets (mainly Greece) until the EFSF became fully operational. And the re-activation of the SMP programme for Italy and Spain in August 2011 came after euro area governments agreed to expand the EFSF tools with primary and secondary market purchase facilities. Once the new facilities were operational, at the end of November 2011, the ECB reduced its purchases substantially (see Figure 3). Since then, ECB officials have stressed the need to activate the EFSF to address the countries’ high funding costs. By announcing the new facility at the August Council meeting, the ECB can continue with the purchases based on countries’ meeting the conditions required under the EFSF/ESM programmes.
Spain (in particular) and Italy not ready to ask for EFSF/ESM assistance quickly
Mr. Draghi was very explicit in respect to the conditions for ECB assistance for governments in bond markets, but Spanish PM Mariano Rajoy and Italian PM Mario Monti ignored that part of the ECB statement. In their remarks at a press conference after the ECB meeting, the Spanish and Italian PMs focused only on the point that the ECB regards the current bond market prices of their countries as unacceptable.3 While Mr. Monti, as before, left open whether Italy would request EFSF/ESM assistance, Mr. Rajoy, also in line with previous statements, declined tostate that Spain would ask for such assistance. To us, this is another example of the Spanish government’s poor communication, and highlights the need to restore credibility by getting external monitoring (at least from the EU Commission and the ECB, probably with technical assistance from the IMF). Given the strong resistance of the Spanish government to asking the EFSF/ESM to activate the primary market purchase facility — although a Memorandum of Understanding regarding the required conditionality is already available with the existing bank support programme — and with no planned issuance in coming weeks, we do not expect that Spain will ask for assistance in August. But, probably forced by a further increase in its funding costs, we expect the Spanish government to make a U-turn and to ask for assistance during September. The statements by PM Rajoy suggest that the government is moving slowly in that direction. In order to make it politically digestible, the request for EFSF/ESM aid might come together with a cabinet re-shuffle.
German government also has no interest in activation of additional EFSF packages in August
Spain and Italy are unlikely to be the only countries holding back any quick activation of the EFSF’s primary bond purchase facility. In our view the German government has no interest in pushing Spain and Italy under EFSF programmes quickly for two reasons. First, after calling back all Bundestag MPs from their holiday to approve the Spanish bank bailout package, calling the MPs back for a second time during the summer to approve a Spanish (and maybe Italian) EFSF package would be seen as poor crisis management by Merkel. Second, an activation of additional EFSF measures before the interim verdict of the German constitutional court on September 12 on German participation in the ESM could increase the chance of the court saying that Germany cannot participate in the ESM, until the court makes its final decision, which probably will take another couple of months.
ECB has to provide details of the CGBPP
In addition to requests from Spain and Italy, and approval by the Eurogroup, the ECB has also to set up the details of the Conditional Government Bond Purchase Programme (CGBPP), for which the ECB’s risk, market and monetary policy committees will make proposals. So far, we learned from Mr. Draghi only that the CGBPP would be transparent in respect to countries and amounts. He also said that the secondary market purchases would focus on the shorter end of the yield curve. The ECB has to address the question of sterilization, with which we expect (unless there is a complete U-turn in respect to risks of deflation) the ECB will continue, but probably with longer dated, ECB bills rather than one-week term deposits. In our view the key questions from investors will be 1) how large is the ECB package is (what does the ECB understand by “adequate”?), 2) over what time frame the purchases will be conducted and 3) if the ECB will pre-announce the targeted size of the purchases at the beginning of the programme. Another big unknown is how the ECB wants to address investors’ concerns on the ECB’s de-facto seniority status.
EFSF/ESM and ECB purchases have at least to match gross debt issuance in order not to disappoint markets
To us, the minimum for an adequately sized bond market support facility, in order not to completely disappoint markets, has to be the full amount of a State’s planned gross bond issuance. While we do not have a financial assistance facility agreement for the ESM, such an agreement exists for the EFSF. According to this, while exceptions are possible, the EFSF can generally purchase no more than 50% of the targeted issuance at an auction. Based on this amount of EFSF (and probably ESM) primary market purchases, the ECB would then have to purchase at least the same amount of bonds in the secondary market, probably concentrated around auctions.
Spanish sovereign funding requirement for remainder of 2012 would probably require an increase in the size of the existing bailout programme
To be concrete, based on our calculations of the public deficit — assuming that the deficit is equally distributed over the year — and assuming that Spain remains able roll over its treasury bills, the total funding requirement for the remainder of 2012 is around €92bn. This would mean that, of the existing €100bn programme, the funds of around €35bn to €40bn currently not earmarked for bank-recapitalization would not even be enough to cover 50% of the targeted auction volume up to the end of the year. We consider that to assume that there will be any unused funds from the bank bailout programme is anyway very optimistic. As a consequence, there has to be an immediate extension of the size of the Spanish programme, which probably will increase the hurdles for Spain and Germany to agree to such a programme, or the ECB has to become willing to buy a larger amount in the secondary market than the EFSF would do in the primary market.
We hope by this point readers realize why the market was very correct in its initial selling response... But let's continue onward to our favorite, and Europe's most hated, topic: math.
Spain and Italy would require around €700bn of support for a two-year support programme
The market will likely be disappointed by a purchase programme up to the end of 2012 only. We think that it will require at least a programme for one year (end 2Q 2013) or better for two years (end 2Q 2014) to make investors feel more comfortable. For Spain, a programme matching the full debt issuance for one year would have to have a volume of around €177bn for one year and €306bn for two years. Italy (also assuming that the programme starts immediately) would require a volume of €197bn for one year programme and €397bn for two years (see Figure 4). So both countries under programmes for two years would require funds as large as €703bn, which would have to be covered by the EFSF/ESM and the ECB, as in our view the IMF is unlikely to participate in such bond support programmes.
And so we finally get back to the crux of the issue, and to the Deja Vu topic of just where the money to fund Europe will come from. Recall that the EFSF leverage, to get it to €1 trillion, was the sticking point of European hollow promises in September of 2011. That entire line of thinking promptly disappeared after it was made very clear that not only can such a structured vehicle ever be completed, but that there is nowhere to fund said vehicle from. In other words Europe still needs between €700 billion (just for Spain and Italy) and €1 trillion to prefund itself for two years. This is an issue that will not go away on its own if people simply close their eyes. All Europe has done now is to shift the rhetoric to one where the ECB may, potentially, if Germany ever agrees to it, pay for some of the prefunding fees, even as the final invoice still says €1 trillion give or take. So far Germany has not agreed to anything and will not until Spain and Italy admit, loud and clear to everyone, they are broke, in the process allowing Germany to slowly commence establishing sovereign oversight.
Which in turn brings us back to square one.
If the ECB takes half of the bond purchases, the EFSF/ ESM would be able to support Italy and Spain for 2 years, but not much longer
The maximum combined lending capacity of the EFSF and the ESM (assuming it gets the green light from the German constitutional court on September 12) is only €700bn and out of this, €192bn have been already committed to the existing programmes for Greece, Ireland and Portugal and around €65bn to recapitalize Spanish banks. Furthermore, around €10bn will be probably needed for a Cyprus Programme, which is likely to proceed in September (see Figure 2 on the front page). Ignoring the need for further funding for Ireland and Portugal, which in our view are likely to request second bailout programmes, and a smaller use of the Greek programme (as the Troika in our view is likely to halt the programme soon) this would leave the EFSF/ESM with a lending capacity of around €433bn. This would be large enough to cover 50% of the expected €703bn of gross bond issuance of the Spanish and Italian sovereign, but is unlikely to last for much longer. This would mean that the size of an ECB CGBPP for Spain and Italy would be at least around €350bn, but in order not to exhaust the EFSF/ESM completely in a short period of time, the CGBPP probably has to be larger.
Going back to our favorite topic: subordination - Citi once again makes it all too clear that any suggestions by wild eyed optimists that the ECB, or any other rescue mechanism, can ever be pari passu with existing sovereign debt, is idiotic.
Difficult to change the ECB’s de-facto seniority status
After setting a precedent in the Greek PSI that Eurosystem government bond holdings purchased under the SMP are senior to the existing bondholders, it will be very difficult to change that perception. Around the Greek PSI, ECB officials said that they would not be part of the private sector that was covered by the PSI. Even if the ECB participated fully in a second Greek restructuring programme, or unilaterally accepted haircuts on its Greek bonds, it would not change the fact that in a first round of debt restructuring the ECB was not pari passu. To us it is hard to believe, that the market would lose these fears, if the ECB puts a new name on the programme — CGBPP instead of SMP — without becoming more explicit on its seniority status. Even in the case that the ECB explicitly said that it would be pari passu with existing bond holders — which the ECB’s risk committee would probably try to prevent — it is uncertain if the market would accept this. The market has learned that while the euro area member states accepted quite a substantial reduction in the NPV of the bilateral loans to Greece (through interest rate reductions and maturity extension) the bilateral loans did not get the haircut of the outstanding volume of the liabilities that the existing bond holders did in the PSI. By giving up its de-facto senior status, the ECB probably will get more criticism from creditor countries like Finland and Germany.
Finally, the ECB lawsuits begin.
Question of time before ECB is before the ECJ for bond purchases
Particularly in Germany the criticism by politicians and the media of the ECB has increased substantially since Mr. Draghi’s London speech. Former ECB Executive Board Member Jürgen Stark stressed in a radio interview on July 31 that it would be difficult to distinguish between primary and secondary bond purchases. In his view the SMP purchases had the only target of reducing the funding costs of the periphery sovereigns, which was a contribution to prohibited sovereign funding. Mr. Stark added that, at least for the last two years, the ECB has breached the EU treaties, but that so-far no one has brought the issue to the European Court of Justice (ECJ). While we do not expect that the German government, which is unlikely to comment much on the ECB’s new bond buying plans, will follow the advice of some FDP politicians to bring the ECB to the ECJ for breaching Article 123 of the TFEU, to us it is just a question of time before such a complaint is made. A recent article published by the newspaper Die Welt provided a guideline on how to bring the ECB to the ECJ or the German constitutional court.
Ultimately the question is how long will the German people agree to an open-ended rescue fund sourced primarily by Germans. If the recent pick up in media rhetoric is any indication - not long.
German parliament has to approve Government decision in respect to ESM
Based on German national law, the Bundestag (at least through a 9-MP sub-group) has to be involved in ESM decisions, meaning that the German representatives in the ESM Board of Governors have to vote “no”, unless they have specific Bundestag approval. So far, there has always been a broad majority in the German parliament for government proposals in respect of the Euro area rescue mechanisms. In our view this is no longer assured. The first big test of Germany’s willingness to do “whatever it takes to preserve the euro” will probably be the change in the number of ESM instruments (Article 19 of ESM Treaty), which would empower the ESM to recapitalize banks directly. As the SPD wants to have much stricter conditions for giving the ESM the right to recapitalize banks directly as foreseen in the June 29 Summit agreement (single bank supervisor established), they probably will not agree to a change in the tool box.
SPD and Greens are open to give ESM right to get funding from the ECB
In the ECB funding-related and ESM leverage-related questions, the SPD and the Greens probably will be in favor of giving the ESM additional rights, because they want to introduce a system that makes the rescue mechanism larger and more transparent. As Jürgen Trittin, the head of the Greens’ parliamentary group in the Bundestag, regards a leveraged ESM as an alternative to their preferred option of a Debt Redemption Fund to deal with the crisis, they probably will agree on this and it seems that the SPD has a similar position. However, Angela Merkel’s CDU and even more so her coalition partners CDU (the Bavarian sister party of the CDU) and the FDP are strongly opposed to giving the ESM access to ECB funding or to increase the lending capacity of the ESM. While Angela Merkel might eventually make a U-turn on the question, we doubt that the rest of the coalition would follow her. In that respect, a possible decision to give the ESM access to ECB funding in the German Parliament probably would be combined with a vote of confidence, which we think Merkel would be likely to lose.
And the punchline, literally, for Merkel:
German government increasingly fragile — temporary grand coalition probably will agree on changes in ESM status
Facing the threat of a break up of her government, Angela Merkel is likely to stay firm at least for a while and will block the access of the ESM to the ECB funding capacities. In that respect, the ECB buying bonds alongside the EFSF/ESM reduces pressure on her side. However, given the increasing amount of government MPs that feel uncomfortable with recent ECB action and the overall developments in the European rescue activities, Angela Merkel’s increasingly fragile government might break up along one of the upcoming decision on the rescue packages, either in respect to the ESM toolkit, the continuation of the Greek loan package, or the approval of the Spanish and Italian requests for EFSF assistance. Hence, the centre-right coalition in Germany might become another victim of the crisis. If the current government breaks up and new elections are currently not possible (because of an unconstitutional election law), we would expect an interim grand coalition of CDU/CSU and SPD to run Germany. With a larger influence of the SPD, such a government would probably be more constructive in respect of rescue measures. However, while there seems to be some chance that the CDU would agree to the SPD proposal of a Dept Redemption Fund, with uncertainties in respect to the German constitution, we regard it more likely that there would an agreement to allow the ESM to tap the ECB funding facilities.
We don't. Which together with all of the above, we contend that - yes, the market did get it right initially when it sold of. And it will get it right again. Because Draghi did not have a master plan and all he can do now is make it up on the fly, just as Europe has been doing for the past 3 years. And even if he did, what Draghi or the anti-German members of the ECB council think no longer matters: what does matter is what Germany wants. And what Germany wants, it gets, which for all those still confused is simple - to keep Europe constantly on the edge, and the EUR low. After all for the German export industry a collapsing periphery is merely leverage to preserve its viability and keep its profitability going as the trade off to the hundreds of billions in sunk costs via TARGET2, which is merely the public financing opportunity cost to preserving a Eurozone which at this point few if any realistically expect to survive. If that means extracting as much benefit which funding a lost cause, so be it.
The irony in all this is that Bankia was almost right: however, instead of handing out Spiderman towels, it should have used Batman as its "deposit-challenged" symbol. At this point he may be the only one who can possibly prevent the destruction of Europe's Gotham - Spain, which, however, paradoxically is the only thing that will lead to its restoration.
In retrospect perhaps Ra's al Ghul was on to something...