Europe’s Three No’s in Two Parts: Part I
The European debt crisis is the single most important driver of the global capital markets and will continue to be so well into next year. While observers have their favorite proposals how the crisis can be addressed and closure finally brought to the crisis, which is extending into its third year, most do not seem politically realistic.
Without a clear viable solution, many believe the euro zone will disintegrate, or at minimum one, or more countries, will leave the monetary union in 2012. These darker scenarios cannot be ruled out, and on some level they are more likely insofar as more people seem to think they are. Yet to the extent that the policy advocates are essentially saying “my way or the highway” they are overstating the case.
Rather than some binary situation of proposed solution or failure, there is a third way and it is actually this third way that most likely characterizes the investment climate in the period ahead. It can be summed up as three no’s: 1) no ECB sovereign backstop, 2) no European joint bond and 3) no euro zone break up.
No ECB Sovereign Backstop, but Liquidity Galore
On December 16th as Fitch, the French-owned rating agency, placed on credit watch a number of weaker European countries (Cyprus, Slovenia, Ireland, Spain, Italy, Belgium) and cut France’s credit, outlook to negative, explicitly recognized that “a comprehensive solution to the euro zone crisis is technically and politically beyond its reach.”
It echoed the concerns of many identifying the problem as an absence of a credible financial backstop. Fitch argued that the situation requires a larger commitment from the ECB to mitigate the risk of a self-fulfilling liquidity crisis.
The ECB is unlikely to do what Fitch advises. Yet ECB is not sitting on its hands either. The new ECB President Draghi has hit the ground running. The main refi rate is now back to its record low of 1% after being hiked in Q2 and Q3. Given the economic and inflation outlooks, further easing of monetary policy in Q1 2012 is likely.
Under Draghi, the ECB unleashed a wave of liquidity that many in the market do not seem to fully appreciate. The cut in reserve requirements frees up 100 bln euros. The lower dollar swap rates, with the Fed, provided another $50 bln+ (38.5 bln euros). The ECB lengthened the long-term repo operation from one to 3 years.
Banks can borrow as much as they want from the central for three years at the refi rate. They are limited only by their desire and collateral. The ECB also liberalized further its definition of acceptable collateral.
There are two auctions for the three-year long term repo operation (LTRO): December 21 and February 3. The former is arguably the most important economic event on the calendar before the end of the year.
There are two main uncertainties surrounding the December 21 operation. The first is the size—how much are banks going to borrow. The second is use—what are they going to do with the borrowed funds.
The demand for funds is complicated by the fact that a seven day repo operation and a three-month operation are expiring on the same day. Banks can distribute their borrowing amongst the different tenors and prior one year funding can be rolled into the three year facility, which can be repaid after one year.
Initial news wire surveys of banks, many of whom are likely to participate in the 3-year operation, show a range of expectations between 200 bln euros at the low end and 500 bln euros at the upper end. The more that is borrowed, the more the immediate liquidity concern diminishes, the greater the market’s appetite for risk (limited as it were by less participation over the holiday period).
Whereas how much banks use the 3-year facility will be known quickly, what they will do the funds will be less transparent. There are two broad courses of action. The first is a type of re-leveraging. Taking money at 1% money from the ECB and using it to buy sovereign bonds.
This is what French President Sarkozy advocated. In effect, if the ECB will not backstop the sovereigns directly, it can do so indirectly through providing more and more liquidity to the banks, who then can buy the sovereign bonds. The carry looks attractive; borrowing from the ECB at 1% to a 3-year Italian bond yielding 5.5%, or taking some duration risk and buy a 10-year bond yielding closer to 7%. This is one channel of profit growth.
Yet there are more powerful incentives in the other direction, toward de-leveraging. At the same moment that banks have an opportunity to buy sovereign bonds, the European Banking Authority is telling banks that primarily because of their exposure to sovereigns, they need to raise 115 bln euros of capital.
There also seems to be complicated stigma effect as well. Often, and especially during the crisis, a barrier to use central bank facilities, may be the negative perception by investors, as it is seen as a sign of an underlying problem. However, the stigma now might not lie with drawing on the three-year facility, but in being perceived by investors (and rating agencies) to be buying sovereign bonds.
The European banks may borrow 3-year money from the ECB but not recycle it to buy sovereign bonds. Banks face strong pressures to reduce liabilities. Of course, some banks, probably smaller banks, may increase their holding of sovereign bonds. However, it is difficult to envision the large global players to alter their course that has led them to sell peripheral bonds in recent months.
Finally, there are distortions in the collateral market created by this circuitous funding and increasingly this has become a more salient market factor. It may be what was behind the recent Spanish auction in which the government raised nearly twice the amount it had sought as banks accumulated cheap collateral (which means relatively high yielding sovereign paper). It may have also been the impetus behind the recent drop in French yields, despite the officials seeming to prepare the market for a loss of France’s triple-A rating.
Expectations of large banks borrowing money from the ECB to buy sovereign bonds to use as collateral to borrow more money from the ECB does not appreciate the risks involved. The cost of hedging and insuring sovereign risk has risen. Also, if the collateral is a sovereign paper and the sovereign is downgraded, or if the collateral loses value for another reason, the bank will have to pony up more cash or collateral.