Goldman Sachs has for the time being been very quiet in joining all of its colleagues from around the street in screaming for an immediate intervention by the ECB or else. The reasons are glaringly obvious: with a Goldman alum in charge of the ECB, and a 23 year Goldman veteran acting as ambassador to Germany, whatever Goldman wants, Goldman will get, without the need for convincing pitchbooks and dramatic expostulations that the world is ending unless... Intuitively it makes sense for Goldman to wait: after all why not take advantage of the situation a la Bear and Lehman, and wait for 3-4 major European banks to collapse, which will be the green light for Goldman to do what it does best: step in and fill the financial and power vacuum. Needless to say, when UniCredit, Commerzbank or Raiffeisen are down, the ECB will have no choice but to intervene with or without the Fed's help. Which is why anyone looking for clues as to what will happen in Europe has to focus on Goldman alone as we already know too well how everyone else is axed. Luckily GS' Francesco Garzarelli and Huw Pill have just released a much overdue note presenting just how the firm feel ont he topic of Europe's continuation as a going concern, or, alternatively, collapse. While we present the full note below in its entirety which naturally seeks to avoid broad panic, here are some notable extracts from a nuanced read: "considering how much damage to confidence has now been inflicted, one must also entertain the possibility that the intensification of market tensions and/or deterioration of economic activity reinforce each other feeding domestic political and social pressures precluding a final agreement among EMU member states from being reached. In this case, rather than being the ‘forcing mechanism’ that drives agreement, the economic and financial environment could feedback into the political process in a negative way, leading to a vicious downward spiral and, ultimately, to the failure of the Euro project." Simply said "an alternative scenario of a ‘break-up’ of the Euro area certainly cannot be ruled out", which leads to Goldman's conclusion: "For the same set of reasons, as the ‘end game’ approaches the rally in AAA-rated Euro area sovereign bonds (Germany’s especially) no longer seems sustainable and could reverse in coming weeks. In our base case of more intrusive control on future deficit financing, the core countries will, in exchange, have to shoulder a greater part of the legacy credit risk of their peers if they want to keep EMU alive. In a ‘break-up’ scenario, the creditor ‘core’ countries will be confronted with a wave of insolvencies, which would also worsen their fiscal position. And in the middle ground between these two outcomes, where we currently stand, the ECB will be intermediating growing intra-Eurosystem imbalances. Through this monetary channel at the heart of EMU, the ‘shadow’ credit risk of the core countries is already rising, and at an increasingly rapid pace." As expected, it appears that Goldman sure will like occupying those European bank HQs for about $1 in equity.
So, starting with Goldman's conclusion:
The Rising ‘Shadow’ Credit Risk in the ‘Core’ Countries
To summarize, we interpret the current turmoil in financial markets and resulting weakening of the real economy as forcing mechanisms for agreement across EMU countries on fiscal governance to emerge: The history of European integration is littered with examples of crises forcing change. Viewed in this way, the current pain is a (necessary) part of the resolution process.
With market pressures mounting, economic activity weakening sharply, electoral pressures becoming more intense in some key countries, and the need to rollover large blocks of sovereign and bank debt in the New Year, the need for a breakthrough to the political impasse is increasing. Such a breakthrough should lead to the formulation of a road-map for institutional and governance reform that would limit the scope for undisciplined fiscal policy in the future. If sufficiently convincing, it should pave the way for an at least partial mutualization of the legacy debt of EMU countries, and a more pro-active response by the ECB.
But in order to avoid the large (if difficult to calculate) costs of a Euro area break-up, action on all policy fronts is urgently required. Nor can countries alone – for example, through further and necessary fiscal austerity – correct a situation that has become systemic in nature. The widening in spreads following the appointment of governments in Italy and Spain resolved to fiscal austerity is a case in point.
This makes investing across Euro area sovereign bonds (and the currency) at present time a very difficult proposition. True, spreads are abnormally high relative to credit fundamentals associated with our baseline scenario, as we have repeatedly said. Moreover, the ECB is likely to remain heavily engaged in secondary markets, ‘home bias’ alongside the relaxation of some regulatory constraints should help the primary government bond market, and access to central bank funding will remain unlimited. If the market is a forcing mechanism in the way we describe it, now that Italy and France are under so much pressure could mean a resolution is within reach. But the potential downside associated with break-up scenario is, for the reasons reviewed above, incommensurable. And even assuming that a political agreement on fiscal flows is reached, the exact form of mutualization of the sovereign debt currently outstanding could change expected returns considerably.
For the same set of reasons, as the ‘end game’ approaches the rally in AAA-rated Euro area sovereign bonds (Germany’s especially) no longer seems sustainable and could reverse in coming weeks. In our base case of more intrusive control on future deficit financing, the core countries will, in exchange, have to shoulder a greater part of the legacy credit risk of their peers if they want to keep EMU alive. In a ‘break-up’ scenario, the creditor ‘core’ countries will be confronted with a wave of insolvencies, which would also worsen their fiscal position. And in the middle ground between these two outcomes, where we currently stand, the ECB will be intermediating growing intra-Eurosystem imbalances. Through this monetary channel at the heart of EMU, the ‘shadow’ credit risk of the core countries is already rising, and at an increasingly rapid pace.
And then proceeding backward:
Goldman on how the risk of a Euro ‘Break-Up’ is starting to be priced
The situation in the Euro area funding markets took a sharper turn for the worse following the Greek government’s announcement at the beginning of November that there would be a referendum on the austerity measures associated with the second Greek financing program. In response to this announcement, policy authorities at the highest level started to make explicit reference to the possibility of a country leaving the Euro area and (by implication) re-introducing a national currency. Although the Greek referendum was eventually aborted, such references to a ‘break-up’ have led to an escalation of market tensions, as the whole structure of EMU was formed on the basis that adoption of the Euro represented an irrevocable commitment.
No sovereign issuer, not even Germany, has been immune to the ensuing escalation of tensions, suggesting that the sovereign and banking crises have now assumed a fully systemic dimension: investors are increasingly questioning the survival of the Euro and the Euro area. In this context, French bonds have suffered in particular, owing to the large size of France’s banking sector and its reliance on wholesale funding, the significant exposure of these banks to peripheral sovereigns, and the state’s implicit guarantee of its banks. France is also currently debating its 2012 Budget and the opposition Socialist party (which controls the Upper House) is resisting the introduction of fiscal restrictions in the Constitution.
In currency markets, in spite of a sharp increase in option skew, the spot Euro exchange rate against the Dollar has declined moderately up to now, considering what is at play. As Thomas Stolper and team have argued in our Foreign Exchange Research contributions, the dislocation in sovereign and bank funding markets has largely been reflected in intra-Euro-area flows across countries (as ‘home bias’ has increased), rather than capital flight from the Euro area as a whole. On the contrary, inward flows have picked up, reflecting the sale of foreign assets from financial institutions.
Moreover, the ECB’s full allotment policy against a wide collateral pool (extended in some cases by national provision of Emergency Liquidity Assistance, or ELA, where depository institutions can pledge poor quality assets that are no longer accepted in the ECB’s repo operations to obtain cash) has played a significant role in intermediating these intra-Euro-area flows. This has led to an accumulation of credit risk at the ECB and rising intra-Eurosystem (im)balances (sometimes labeled TARGET 2 imbalances). This assumption of credit risk implies that creditor countries (like Germany) face significant losses in the event of a disorderly dissolution of the Euro area, and this helps explain why even German yields have come under upward pressure.
But, as the market situation deteriorates and the possibility of a break-up of the Euro area is re-priced, there is the potential for capital flight to occur from the Euro area as a whole (rather than from specific countries within the Euro area to other countries within the Euro area), creating pressure for a weaker Euro exchange rate at least until the policy stalemate is resolved.
Goldman on "Market Pressures as a ‘Forcing Mechanism’" - as in the same pressures that forced Silvio to step down in less than 48 hours.
To be clear, our base case remains that the Euro currency and the Euro area will survive intact. We are of the view that the intensification of market pressures in the ‘core’ countries (notably France and the Benelux) will play a crucial role as a ‘forcing mechanism’ of a political breakthrough in the ongoing negotiations over the Euro area governance structure (and news of a Franco-German initiative to be unveiled ahead of the EU Summit on 9 December is a step in this direction). In return for some ‘socialisation’ of the risk in the stock of outstanding sovereign liabilities (the ‘debt overhang’), weaker EMU countries are likely to agree to being subject to more intrusive scrutiny over their public finances and ultimately a loss of fiscal sovereignty should adverse circumstances emerge.
But whereas the ‘flow problem’ of this debate is becoming more intelligible along the dimensions discussed earlier, how the ‘stock problem’ will be handled is still very unclear. Indeed, a number of schemes to achieve what a mutualization of credit risk can be envisaged.
The ‘cleanest’ (and thus, given the markets’ search for clarity, probably the most effective) solutions offer an unconditional underwriting of that risk among EMU members. The refinancing of existing public debt and new deficits through the issuance of joint and several Eurobonds would give an unambiguous signal that all Euro area sovereigns stand behind the legacy debt and that the credit risk in individual countries’ liabilities will be shared on all countries of the area.
Potentially unlimited purchases of sovereign debt by the ECB to enforce pre-announced yields caps would achieve a largely equivalent result in economic terms, since – as we have argued in the past – the Eurosystem’s balance sheet and capital structure offer an alternative vehicle to achieve such Euro area-wide risk sharing. In order to sterilize the injection of liquidity resulting from these purchases, the ECB could issue term bonds under its own name, which de facto would replicate the structure of a joint and several Eurobond.
However, the likelihood of such a ‘clean’ solution being introduced is, in our view, low, at least at this stage. The clarity of the commitment to risk-sharing that underpins these schemes stems from its unconditional nature. But those providing the financing are unwilling to offer such an unconditional commitment. Absent a pooling of the tax base across countries, both these outcomes would result in a transfer of credit risk onto the shoulders of the existing AAA-rated issuers, either explicitly or indirectly via the ECB’s balance sheet.
Leaving aside the binding constitutional impediments in taking this route, the German authorities are not prepared to ‘sign a blank cheque’ underwriting the fiscal situation throughout the Euro area, as an unconditional Eurobond would imply. Equally, the ECB’s reluctance to cap sovereign yields stems from its concern that the unconditional commitment this implies could soften governments’ budget constraints and again offer opportunities to free-ride on the fiscal strength of others, leading to fiscal indiscipline and accumulation of new imbalances. No wonder, the ECB requested a series of fiscal measures before starting to purchase Italian debt this past summer.
Given these constraints, different schemes are required that recognize the need to satisfy the concerns of those effectively providing the underlying guarantee (the ‘hard’ core countries around Germany and the ECB), and concomitantly to impose discipline on governments to ensure that new imbalances do not emerge in future, while offering the clarity and simplicity of support that the financial markets currently demand. Said differently, the challenge facing the European authorities is to offer a sufficiently unconditional guarantee of credit risk socialization to satisfy markets, while simultaneously making the guarantee sufficiently conditional to discipline governments (incidentally, the same principles apply in relation to bank funding). Stated that way, the magnitude of the challenge is clear.
Europe's only hope: "Towards a Mutualization of the Legacy Debt"
The ongoing discussions in Brussels and between European capitals are edging towards formulation of schemes that address these issues, and some basic elements of an agreement are starting to transpire. Specifically, the fiscally stronger countries are prepared to accept some form of mutualization of the risk in the existing debt stock in return for a new, enforceable scheme for fiscal discipline in the future. That way, they are not writing a ‘blank cheque’, i.e., underwriting the rest of Europe forever without first ensuring a pooling of their tax bases, but rather making a finite one-off (albeit large) payment to cover the mistakes of the past and create opportunity for a ‘clean start’ by countries currently under market pressure. In our view, such mutualization of the risk in national debt overhangs should be enough to ensure the survival of the Euro and the Euro area, from which the fiscally strong countries – that underwrite this mutualization – benefit significantly.
Judging from the material emerging from Brussels and other capitals, technical work on various aspects of these schemes, each carrying its pros and cons, would appear reasonably advanced. A proposal to set up co-Investment Funds (CIFs) for sovereign bonds of selected issuers seeded by the EFSF (which would take the first loss on any credit event) forms part of the list of options under consideration. The EU Commission published last week a lengthy Green Paper on the design of Eurobond instruments. These could be used to fund a sovereign ‘bad company’ warehousing a large chunk of legacy liabilities of EMU members, until they run off. Of course, making decisions operational will take time: Treaty change in the EU is a lengthy and risky process, as we have seen in the past.
Given such reassurance from governments, we believe the ECB would move from its existing stance of passive ‘containment’ of bond market tensions to a more forceful response. The ECB’s actions would represent a ‘bridge financing’ of sorts ahead of Treaty revision regulating the flows, which would be associated with the mutualization of the risks in the debt overhang. This shift could take place ahead of the heavy calendar of bank and sovereign bond rollovers starting in the first quarter of next year. Any increased purchases of sovereign debt arising from this new stance could be justified as a form of ‘credit easing’, in the face of already low ECB policy rates, a substantial weakening of economic activity amplified by the ongoing contraction of bank funding avenues, and the potential emergence of downside risks to price stability as inflation falls. Our forecasts and current PMI readings imply the Euro area is already re-entering a recession, supporting the case for further monetary easing of this type.
Goldman's observations on a Potential Break-Up Scenario
The above scenario sketches one path on how the Euro can be sustained, even from the current unfavorable starting point. Given that negotiating and agreeing Treaty changes (which, despite their current presentation by European leaders, are hardly ‘limited’) is necessary to resolve the current impasse but likely to be a drawn-out process, it is not difficult to foresee the recurrence of potentially destabilizing events of the kind we have witnessed in recent months during the interim: Failing bond auctions, political instability, bank failures, and simply outright disagreement. And all of this is occurring in an environment where a deepening recession is likely to make achieving current fiscal targets extremely challenging.
Our baseline case that policymakers will ultimately do what it takes to avoid such an outcome requires political actors to behave in a rational and consistent manner, and assumes there will be no further destabilizing unanticipated ‘shocks’ along the way. But particularly considering how much damage to confidence has now been inflicted, one must also entertain the possibility that the intensification of market tensions and/or deterioration of economic activity reinforce each other feeding domestic political and social pressures precluding a final agreement among EMU member states from being reached. In this case, rather than being the ‘forcing mechanism’ that drives agreement, the economic and financial environment could feedback into the political process in a negative way, leading to a vicious downward spiral and, ultimately, to the failure of the Euro project.
In short, an alternative scenario of a ‘break-up’ of the Euro area certainly cannot be ruled out. Given the intensely political nature of the determining process at play, assigning probabilities to our baseline scenario and alternative ones is difficult. What we can say at this stage is that the next several weeks will be crucial: If a political breakthrough of the type described above is not achieved before the refunding cycle picks up in earnest in mid-January, the probability of a spiraling out of control towards a break-up would substantially increases.
Against this background, we offer a few considerations on the implications of the Euro’s demise:
- A break-up of the Euro area is, by definition, an extra-institutional event. It was not foreseen in the Treaty establishing EMU and thus there is no established legal procedure to govern the process. This implies that any such process is likely to be plagued by uncertainty and chaotic. We are in the realm of ‘unknown unknowns’ (or ‘Knightian uncertainty’ in economics parlance), rather than risks that can be associated with probabilities. By its nature, this scenario is therefore difficult to describe and hard to price and/or assess from a risk management perspective.
- Contrary to the opinion of some observers, we hold the view that the likelihood of an ‘orderly break-up’ or ‘managed divorce’ (the dissolution of Czechoslovakia is sometimes held up as a precedent) is low. Beyond the fact that there is no ‘pre-nuptial’ agreement in the event of such a divorce, markets operate more quickly than political negotiations. As soon as the prospect of an exit or break-up is entertained, we would expect a run on sovereign bonds and bank deposits in the weaker countries as investors seek to protect themselves from being paid in a devalued currency. And measures taken to limit these flows (and, by implication, to limit the exposure of other countries to any such devaluation) would lead to the dissolution of the monetary union ahead of any formal political announcement, as they would disrupt the equivalence between Euros held in one part of the Euro area and those in another (which is the key feature of monetary union). Moreover, given the legal and economic uncertainties mentioned above, such an eventuality could also precipitate such runs even in the fundamentally stronger countries, as investors seek safe-havens outside the Euro area. Recent experience with the Swiss Franc illustrates this case. The introduction of ‘exit clauses’ in the Treaty as a punishment for fiscal profligacy would, in our view, be similarly self-defeating.
- Given the deep integration of the European financial system and the deep inter-linkages we and others have amply documented and large intra-Euro-area financial exposures that result (not least on the Eurosystem balance sheet itself, as reflected in TARGET 2 imbalances), the exit of one country is unlikely to occur in isolation. While smaller strong countries – faced with the take-it-or-leave-it choice of keeping the Euro but with a potentially significant erosion of fiscal sovereignty – could possibly leave EMU without inducing a wider meltdown (we say possibly because an ‘exit’ route would have been opened, and this in itself could be destabilizing for the reasons stated in sub 2), in the event of a more disorderly exit of a weaker and/or larger country, the economic, financial, political, and psychological channels of contagion would trigger a wider market malaise, anticipation of further exits and runs on sovereigns and banks that may make further exits hard to resist. More generally, once the supposedly irrevocable commitment to monetary union is broken, the stabilizing mechanisms that result from that commitment break down. In short, removal of one country is unlikely to be an isolated event – it would quickly become systemic.
- The economic costs of a break-up scenario are difficult to calculate, but undeniably large. Implicit in the above discussion are very large disruptions to the system of payments and the financial system at large, as bank and sovereign funding dry up in all countries and – after exit – the ECB is no longer willing to provide alternative financing. More fundamentally, all contracts under domestic law in both the financial and real economies could be subject to renegotiation, as parties to the contracts demand to be paid in Euros or the new currency (according to the position they hold). For example, in the case of a country with a new currency that depreciates rapidly, a large number of firms with domestic income in domestic currency but foreign liabilities in Euros would likely be pushed into bankruptcy.