By Dr. Harald Malmgren
Following Standard 7 Poor’s downgrades of a swathe of Euro member governments including France, Moody’s has also joined in the process of downgrading several of the members, with a warning to France.
The seemingly never ending process of resolution of a rescue package for Greece has resulted in “crisis fatigue” and growing acceptance of the idea of Greek default not only within the Troika (IMF, ECB, and EU) but in Berlin.
We detect a growing consensus in favor of Greek default, either within the Euro financial framework or in a context of exit from the Euro. Gradually, data on Eurozone industrial production, employment, and GDP growth are revealing intensifying recession.
Even the German economy is showing weaker industrial production and employment.
Markets have continued to ignore these negatives, with sentiment buoyed by European Central Bank (ECB) to provide swelling long-term repo operation (LTRO) injections of liquidity to Eurozone banks. The next LTRO round will likely be of the order of €500 billion or more, raising hopes that much of the additional flow of Euros will be used to purchase sovereign debt of Italy and Spain, or be used to expand lending, or both.
It is likely that the February LTRO will not be the last. The ECB is pumping more liquidity and at greater speed than QE liquidity injections provided by the US Federal Reserve in the last couple of years.
More important than the total amount of LTRO is the decision by the ECB to relax criteria for eligible collateral that banks may provide in exchange for Euros.
Among other relaxations, the ECB will now take more corporate loans as collateral. Right now, that may seem safe enough, but if recession strengthens its grip on the economies of the Eurozone corporates will suffer and this collateral will deteriorate in quality.
German government officials and the ECB were relatively relaxed about the lengthening of short-term lending to three years, since a number of German banks had long been begging for delays in implementation of new Basel III capital standards and increased regulatory flexibility during the likely recession driven by fiscal austerity measures in the Eurozone.
However, the more recent ECB relaxation of collateral criteria is causing worry in Berlin and Frankfurt that the ECB may be headed towards accumulation of a mountain of decaying assets while operating on razor-thin capital of its own.
In response to German worries, the ECB has asked central banks in several of the Euro member nations to vet the collateral being offered, and to retain the risk if such capital turns out to be defective or deteriorates. This supposes that national central banks are in a position to backstop such debt, which is doubtful, but it assures Germans that they might be insulated from some of this newly acceptable collateral should it deteriorate.
Eurozone banks are under intensified regulatory pressure to raise capital, or deleverage through a combination of increased capital and shrinkage of assets. The European Banking Authority (EBA) is overseeing this process of trying to strengthen Eurozone banks.
As with many European decision mechanisms, actions being taken by the EBA are not well integrated with actions by Eurozone ministers and the ECB in addressing sovereign debt issues and the recessionary forces generated by fiscal austerity measures. The EU, Eurozone, and ECB machinery is characterized by “silo decision making,” with each committee or ad hoc task force operating with minimal interaction with other economic and financial decision making entities.
Up to now, the EBA has been cautious in imposing “light touch” stress tests which have had little market credibility. The EBA has also tolerated intricate, deceptive accounting manipulations, swapping of assets by banks, and even buybacks of their own debt to offer as collateral, in order to demonstrate “adequacy” of capital and absence of risk.
Under pressure not only from some European governments but also from governments around the world involved in the design of Basel III, the EBA is now trying to force banks to “clean up” their methods of measuring capital and reconcile such measurements with each other so that a common standard of capital adequacy can be applied.
European banks have long maintained accounting practices which obscured their underlying capital. It will be no easy task to change long-established practices with new uniform standards of disclosure and full transparency. The ECB has minimal influence on these matters, and the EBA must cope with regulators in each member government of the Eurozone who have independent powers to approve or disapprove of accounting methodology for their own banks.
During the current conditions of recession and evident slowdown in bank lending, national governments will not be eager to force their own banks to come clean if doing so would result in further contraction of lending to their own domestic private borrowers. The EBA’s pressure to raise capital is being met with stiff resistance in many, or even most cases, as banks are reluctant to dilute shareholder interests with new issuance of shares, and reluctant to seek capital at unusually high cost in a context of market reluctance to buy into Eurozone banks.
As a consequence, Eurozone banks are seeking to reduce leverage by contracting lending and credit lines both internationally and domestically. This is manifesting itself in global credit contraction at a time of weakening global growth. Lending for projects in emerging markets and big ticket items like aircraft sales globally will suffer. It is unlikely that LTROs provided by the ECB will offset this process of deleveraging and encourage increasing lending.
In the meantime, Euro government leaders have agreed in principle on a “fiscal pact” demanded by the Germans. This pact, containing loopholes for “exceptions,” does not really change significantly what was already embodied in previous European treaties, but it is expected to be built into domestic law of acceding governments, thereby adding domestic pressure on governments to carry out their budget deficit reduction commitments.
The pact was primarily needed by the German leadership to persuade the German parliament and voters that something new and decisive was accomplished.
Some governments may have difficulties in persuading their parliaments to approve legislative changes, or may find political need for public referendums. The biggest uncertainty lies in France, where April-May national elections may result in government turnover and rejection of the fiscal pact as presently drafted.
In conclusion, the new fiscal pact adds little to the outlook for the Eurozone’s continuing viability. Neither the fiscal pact nor the ECB’s liquidity largess will provide Euro member governments adequate flexibility to deal with inevitable European and global crises in the months ahead. There is a core problem of the impact of policy fatigue associated with continuing Euro crises which is significantly reducing the political ability of Continental European governments to respond to other global challenges.