Frequent readers know that Citi's Matt King is our favorite analyst from the bailed out firm. Which is why we read his latest just released piece with great interest. And unfortunately for our European readers, if King is right, things in Europe are going to get far worse, before they get better, if at all. Because while one may speculate about political jawboning, the intricacies of summit backstabbing, and other generic nonsense, the one most important topic as discussed lately, is that terminal event that any financial system suffers just before it implodes or is bailed out: full scale bank runs. It is here where King's observations, himself a member of a TBTF bank which would likely be dragged down in any cash outflow avalanche, are most disturbing: "In Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks. The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy....Economic deterioration, ratings downgrades and especially a Greek exit would almost certainly significantly accelerate the timescale and increase the amounts of these outflows." That's right: according to Citi there is a distinct likelihood that, all else equal, the domestic bank sector in Spain will see another €215 billion in deposit outflows.
And while Greece has seen a slow and steady bank run over the past 3 years, which has made it far more palatable for the local financial system, King believes that the days of "slow" outflows are now over: "we think the risks are skewed towards larger outflows occurring considerably more rapidly." Now we won't read too much into this, but following up on Jim Cramer's Meet The Press interview from Sunday in which he explicitly predicted bank runs in Europe absent substantial and urgent policy changes, it appears that from a taboo, it has suddenly become all too cool to predict rapid and violent bank deposit flight in any but the priced to perfection scenario. Hopefully Spain is hip with all this sudden "coolness"...
Before we get into the punchline of King's note, here is a terrific summary of all the less than pleasant capital flows out of Europe's periphery.
And now back to the punchline, the first of which is King's all too spot on definition of a "bond vigilante" as not a "wolf" but a "sheep":
The trouble, as we see it, is that bondholders are not at heart the wolf pack Swedish Finance Minister Anders Borg famously made them out to be. Sheep, or perhaps wildebeest, would be a more accurate description.
Bondholders and depositors alike have only limited upside, but lots of downside. They therefore tend to graze quietly upon their coupons or interest payments, relying on others – such as the rating agencies – to warn them of oncoming fundamental risks. Even if individual investors are often very sophisticated, they are constrained by those who set their benchmarks and risk guidelines, which tend to be much slower moving.
... A sheep, however, which once it starts running, gets the herd moving very, very fast:
Once the flock has been disturbed, though, it can run quite quickly. And once it has changed its mind about a given risk, it can be almost impossible to get it to turn back. Those dropping Spain and Italy from their benchmarks, shifting their mandates towards AAA-only, or moving deposits away from peripherals, are very unlikely to return in a hurry. If anything, we think the risk is of acceleration. And it would seem that, having been disturbed once or twice already, investors are proving more alert to potential signs of danger in Spain and Italy than they were in Greece, Ireland and Portugal. Although the threshold for domestic capital flight looks to be higher than that for a retrenchment by foreigners, there is every sign that foreigners are pulling back already.
Which means what in practical terms? Nothing good if you are a Spanish bank, already on the verge of nationalization:
How far is the flock likely to run? In Greece, Ireland, and Portugal, foreign deposits have fallen by an average of 52%, and foreign government bond holdings by an average of 33%, from their peaks (Figure 18). The same move in Spain and Italy, taking into account the fall that has taken place already, would imply a further €215bn and €214bn in capital flight respectively, skewed towards deposits in the case of Spain and towards government bonds in the case of Italy (Figure 19).
Although large, if these flows occur slowly enough, they might not represent a major problem. After all, Portugal’s banks have managed to replace fleeing foreign deposits with domestic ones, and ECB repo should allow a further ramp-up in banks’ holdings of government bonds.
But we think the risks are skewed towards larger outflows occurring considerably more rapidly. Admittedly there are a great many unknowns, including the potential policy response. But none of these estimates allow for the possibility of domestic deposit flight. In the case of a Greek exit from the euro, that outcome seems highly likely. Nor is there any sign that the flight from Ireland and Portugal is diminishing (if anything, we expect the opposite).11 Moreover, banks’ appetite to buy further government bonds may prove limited if they start to suffer deposit flight – and all the more so if they suspect that deposit flight stems in part from their holdings of government bonds
The rest is superfluous: once the run (either bond or bank) starts, there is no stopping it:
Above all, though, we think capital flight, like so much in markets, is a self-reinforcing process. Provided other depositors and bondholders are grazing quietly, there is no reason to run. But as risks come ever more into the spotlight – whether through the TARGET2 imbalances, benchmark shifts or the threat of EMU exit in Greece – the unattractiveness of the risk-reward becomes ever more obvious.
What is the only possible outcome that will prevent this virtually catastrophic outcome?
To our minds, capital flight will stop only once there is decisive policy intervention. The longer investors have to wait for this, the more decisive it will need to be. Even a Euro area-wide deposit guarantee scheme might struggle to be credible if investors fear the incentives for redenomination are strong enough... Quite simply, investors in ‘safe assets’ need to be reasonably sure they will get their money back. Foreign investors in peripherals can no longer be sure of that.
In a continent in which the leaders of the countries can not agree on the summit lunch menu, let along on coordinated and forceful policy intervention, we certainly don't blame said foreign investors.