Saturday, March 26, 2011

Did the EU Council Just Kick the Can?

As the week ended and the EU Council meeting of March 24/25 concluded, it was as if the week had never begun and all of the prior and continuing debate on a competitiveness pact and  extending the EFSF and establishing a permanent ESM, the bitter Irish question of their higher interest rate, the Irish consideration of default of guaranteed debt which is not national debt exposing senior bond holders of Irish banks, the German and French canard of Ireland's corporate tax being too low when it actually generates more tax on corporate income than other eurozone countries with lower corporate taxes, and the week's events in Portugal, with rising interest rates on its debt and CDS  and short term debt maturing in May and June, rejecting austerity and the international market's adamant speculation it must kneel to EU/IMF bailout, having its government resign had been some funky dream with phantom giants.

It was as if, while peering into the magic mirror, the reflection of another severe financial crisis which could cost European banks 250 billion euro vanished.  Never mind that the proposed ESM funding mechanism was a convoluted everyone guaranteeing everyone by using an inverted capital structure in which, if there was actual need, it would cause a reflexive price action in the bonds.  Here comes an important EU Council meeting with laborious and contentious  preparation at a time when the Irish hold a default trump card, Portugal was rejecting an austerity budget forcing the resignation of its government bringing the specter of another EU bailout front and center under intense flood lights, Spain's banks capital funding is being questioned (will the German banks ever be properly tested?), Greek revenue is declining on higher taxes and fees, the rigorousness of bank stress tests remain negotiable, rising interest rates in Ireland, Greece, and Portugal as the eurozone continues to take no timely and effective action until it is too late, spreading anti-austerity demonstrations and protests in Greece, Portugal, and the UK as well as other eurozone countries, the Finns saying they will vote on no issues until after their April elections, nationalist political movements in France, Finland, and the Netherlands, and the never ending bitter internecine German national political tragic-comedy.  Knock, knock, is any body listening, watching, or paying attention?  Are there no clear fiscal solutions which are not two speed divisive and destructive?

Yet, the proposed ESM was viewed to be divisive.  After a third round of stress tests, Ireland may have to pump 27.5 billion euro into Irish banks which would exhaust 80% of the 35 billion euro bond fund set up last year by the EU.  With Ireland standing to lose over 35 of revenue if the corporate tax was harmonized, many in Ireland thought that it would be best to have no deal, and not play the trump yet, rather than a bad deal if Germany threw its weight around and France continued to tag along.  Germany actually seems to be unable to understand finacial risk figures with German banks having 21.4 billion euro exposure to Irish banks and 64.7 billion euro in loans to Irish businesses.  All of the ESM restructuring talk predictably sent the bonds of Ireland, Greece, and Portugal spinning.  However, much of the restructuring being discussed is just a deepening of the pit with those servicing the bonds having to accept lower wages while the bondholders do not share in the union and keep wages high.  Ireland is contracting not growing.  Ireland is very dependent on exports and is still recovering from 2009, although its 2010 current account balance deficit is only about one fourth of the 2009 deficit.  Portugal has a deteriorating cash position despite believing it has enough to get through debt maturities in May if not June, however, the political situation was untenable to the degree that the ruling party pushed a no confidence vote scenario.  While many believe there is no eurozone crisis as long as Spain remains sustainable, the value of its banks assets are constantly being questioned with mortgages on the books being, perhaps, overvalued by as much as 45% laying the ground work to pressure rates up despite Spain trading very much like Italy in the bond market.

The pessimism surrounding the EU Council meeting was pervasive and on the the 24th Wolfgang Munchau voiced his three scenarios, including break up if Germany continues to insist on limited liability.  Danske Bank in its three scenarios was even darker with default, Germany withdrawing, and eurozone total breakup with possibilities of revolution in parts of Europe.  The EU itself had only a four item agenda: current crisis resolution, future crisis resolution, the pact for the euro, and the Commission’s proposal for reform and extension of the stability pact.  To which was added Libya.  What Europe got was a less substantial ESM with more funding commitment starting in 2013 which gave Merkel political cover in Germany and with an extended funding period over five years beginning in 2013 just after elections in Germany.  The conclusions of the meeting were limited, soft, contradictory, and avoided action on any problem facing the eurozone.  This was seen as a great victory in Germany.  Of course, the day after the meeting the worry over debt and commitments and liabilities  as well as the absolute need to punish surfaced, without any consideration of the effects of haircuts on bonds would have to German banks.

In the rest of Europe the reality was quick to set in with the realization that Greek and Irish bonds have already been discounted making any buy back program inadequate.  The ESM cannot have a triple-A status and an effective lending capacity of 500 billion euro.  The ECB began working on an emergency plan to provide 60 billion euro in medium term liquidity to Irish banks.  A "major" European default still remains the biggest threat to the global financial market.  All of the fanfare in Germany, France, and Italy are premature in the face of Portuguese instability.  The EFSF would in effect be collateralizing or wrapping bonds of restructured bonds which would be guaranteed by the eurozone as a whole.  As of Monday the 27th, Portuguese bonds will not be eligible for delivery in any of the RepoClear single A €GC basket, although LCH.Clearnet will continue delivery of Portuguese government bonds.

Portugal is going to have to come up with some bridge financing from the core eurozone or other international or private sources to insure it can get through June debt redemptions.  Ireland is waiting to see if they will get help with their banks and, if Portugal is forced into bailout, what interest rate they get.  Greece is fighting mounting demonstrations and tax protests.  Anger is spreading against the inequity of austerity is condemning countries forced into austerity, lower wages, and personal family financial sacrifice by the eurozone rules to a future of no growth or very slow and low growth, if they are lucky, while the benefactors (the eurozone countries that export to them) continue to profit from their current account surpluses generated by the faulty construction of the monetary union and refusal to allow the formation of an effective fiscal union.

The EU Council has kicked the can down the road to June.  Will they kick it even further down the road in June until, as is their usual practice, it is too late to act decisively in a timely and effective proactive manner?  The bond vigilantes have been betting NO and winning; there will, consequently, always a next victim until they run out of eurozone countries.  At what tipping point will this credit crisis be recognized as a currency crisis and the global financial market catches contagion?

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