Is the Eurozone Crisis Over?


2014-01-11 By Harald Malmgren

During 2013 the Eurozone financial crisis seems to have dissipated.

Optimistic words spoken by high level Eurocrats asserted that the EZ economy had turned the corner and was gradually recovering, with 1.0% GDP growth likely in 2014.  ECB President Draghi said repeatedly that the ECB “would do whatever it takes” to stabilize the financial markets.

Complacency set in not only among Europeans but also among global investors.

Looking closer, it was German export growth which tipped the EZ growth from negative to positive.

Germany kept competitive, in spite of relatively high exchange rates for the Euro, by keeping German wages suppressed several years running. 

While world trade did recover from its longest, deepest decline since the 1930’s, 2012-2013 showed signs of deceleration of world trade growth, tending towards near zero growth.

Germany’s principal export markets (China and the rest of the EU) have weakened. 

Germany’s export mix of automotive vehicles and machinery and equipment aimed at increasing productive capacity of other nations did work well until much of the world economy sank back into slow growth or recession.

Looking forward, German exports will not likely continue growing vigorously. 

Competitiveness will be diminished as German wages are allowed or encouraged to rise – unless the Euro were to fall significantly.  In that case, inflation would return as cost of imported materials escalated.

In any event, German demographics show rapidly aging population with diminishing young workers to support it.  The cost of the social safety net will grow much faster than tax revenues.

In the meantime, France’s economy is rapidly deteriorating, so much so that it is now reasonable to forecast France as the next Spain in terms of failing banks and failing sovereign credit.  

With Spain and Italy already under extreme financial stress, we can declare the three largest EZ economic engines after Germany are faltering.

The Eurozone as a whole is export dependent.

In a time of world trade slump little power can be expected from its export engine, even if the Euro were to fall sharply, unless the EU used state powers to steal world trade market share from other exporting nations.

The EZ financial market is primarily made up of banks, with nonbank financial entities (shadow banks) playing a small part, and borrowing directly from financial markets on a much smaller scale than in the US.

To simplify, we can say that banks are the financial market in the EZ, providing finance not only for business but also for national and local governments in Europe.

The health of EZ banks, including American, British, Japanese, and other banks operating in the EU determines the health of European credit markets.

In recent months, European regulators have been pressing EZ banks to raise capital ratios, but gathering new investment capital is difficult and costly for EZ banks known to be overleveraged and undercapitalized.

EZ banks have attempted to improve capital/asset ratios by shrinking assets, particularly selling off Asian, North American and emerging market activities and lending.  EU banks were long the backbone of world trade finance, but the exiting of EZ banks has shrunk the availability of trade finance in other parts of the world and opened opportunities for other, non-European banks to take up the slack.

Not surprisingly EM businesses have had to turn increasingly to their own national export-import banks, the World Bank and its IFC affiliate, and the quasi-government export-import banks of other nations.

Addressing national debt crises among EZ member nations since the collapse of Lehman in 2008, the Eurozone complex decision system has explored a number of different means of resolving bank crises.

Gradually, voter pressure in some countries made extending public assistance to private banks with “taxpayer money” difficult.  Germany, the most prosperous EZ member, felt building pressure against bailouts of other EZ members and their banks.  The German Government, reined in by the German Constitutional Court, found that cross-border financial transfers among governments were inconsistent with the Maastricht Treaty and other European Union treaties, and would therefore be illegal.

When the Cyprus bank collapse occurred, the peculiar composition of Cypriot bank deposits presented an especially high level of political discomfort for Germany and most other EZ members.  The deposit base of Cyprus was made up of very large Russian deposits which had been building during and after Soviet Union days, much of which was alleged to be “black money” (tax evasion, Russian mafia revenues, high level Russian government corruption, etc.).

It became politically convenient for the European Commission, EZ member governments, and even the IMF to decide that public bailouts of Cyprus banks could not be allowed, but instead a complex “bail in” would have to be initiated, in which not only investors but depositors with over €100,000 would have to accept impairment of their positions as contributions to the stabilization of Cyprus banks.

This idea of “bail ins” rather than “bail outs” gathered momentum among EZ governments and parliaments and soon became the new template for EZ bank rescues wherever they might take place. 

The EZ governments also agreed to seek to establish a “bank union” consolidating supervision of the largest banks throughout Europe.  It was agreed that a new EZ fund would gradually be assembled in the amount of €55 billion to be available for assistance in the event of bank failures, and the ESM would be made available to help stabilize financial markets during bank crises.

But in 2013 conflicting national interests in banking blocked progress. 

Some governments wanted to retain a primary role for their own national regulators.  Some wanted to exempt all but the very largest banks from transnational oversight.  Some wanted the scope and authority of an EZ regulatory supervisor to be limited, and standards for participating banks would need further scrutiny to prevent unintended crises or credit contraction in the process of transition to a bank union.

In 2014, the ECB, the EZ national member central banks, and the EZ governments are still at a stalemate on how to proceed. 

All await the formation of the new German coalition government and its parliament to decide what might be permitted by way of national support for collective stability, and the German Constitutional Court in Karlsruhe to make a determination about what form, if any, of cross-border financial transfers among member governments would be consistent with German law.

Merkel and Schauble have several times observed that some kind of rewrite of the European treaties would likely be needed, possibly just the treaty establishing the ECB and the Euro.

However, treaty renegotiation would likely open up many new controversies in national capitals and would likely take months of parliamentary debates, potential demands for referenda, and possibly open new controversies, particularly regarding the fiscal austerity policy priority, but also basic reconciliation of national laws and regulations.

In spite of continued impediments to a bank union agreement, the ECB is trying to maintain investor confidence in the EZ financial market.

On 9 January, 2014, the ECB held steady its previous interest rate decisions, but President Draghi used his press conference to make subtle changes in ECB characterization of the Eurozone outlook.  Reassuring words were used to indicate the ECB’s expectation of recovery of EZ growth and stabilization of financial markets.

But then Draghi made several warnings.

Euro area may face prolonged low inflation. Euro area growth risks remain on the downside, and unemployment remains high. He observed that balance sheet adjustments would weigh negatively on Euro area activity. He also warned that the slow pace of EZ economic and financial reforms posed additional downside risks.  Draghi was essentially guiding the Eurozone outlook downward with these emphases on negative risks.

Regarding the “ordinary monetary transactions” or OMT, he was silent, as the ECB remained uncertain about the Karlsruhe Court determination on the legality of the proposed OMT, or a rewrite of Eurozone or EU treaties.  Essentially, Draghi’s promise the ECB “would do whatever it takes” remains an empty promise without further acquiescence by Germany.

As for the Eurozone economy unemployment picture, it is growing darker day by day.

The unemployment rate in the EZ as a whole is at all-time record high of 12.1%.  Unemployment in Italy, Spain and France is at record levels, and youth unemployment at staggering levels: 41.8% for Italy and 57.7% in Spain (greater than in Greece).  It should also be noted that in Germany social unrest resulting from extremist activities and multicultural animosities concentrated in entire cities.

German commentators describe geographic regions as “a test to the breaking point” of social and regional centrifugal forces.

Past European bank stress tests turned out to be ineffective in identifying both the scale and the location of risks among European banks.  It may be recalled, for example, that Dexia Bank was given highest endorsement of its financial strength after the first stress test, only to be followed by collapse of Dexia and a multinational rescue by France, Netherlands and Luxembourg (damage beyond private sector loans to critical lending for local governments in the French/Dutch/Luxembourg area).  It had been hoped by financial market investors that the new ECB Asset Quality Review (AQR) of banks would help renew investor confidence by dramatic increase in EZ bank transparency and rigorous application of common accounting standards including measurement of capital adequacy.

However, EZ banks have been pushing back vigorously, warning that Basel III capital standards and rigorous AQR reviews would inevitably result in a sharp fall in credit for the Eurozone, at a time of fragility of economic recovery.

As a means of establishing credibility of the AQR, one initial avowed intention was to identify and push into failure specific banks that were found to be insolvent.

However, it has subsequently been informally agreed among EZ regulators that bank failures should be avoided.

It has also been jointly recognized that logistical problems of carrying out detailed examination of more than 100 large banks would not be possible in a short time period.  Contentious issues of sovereign debt risk measurement and exposure are likely to be postponed, and common value at risk models would not likely be attempted.  As for Basel III standards, both regulators and banks have been pressing for further postponements of Tier 1 capital standards, so this will not be directly addressed.  Common standards for non-performing loans (NPL) will not likely be agreed.

Every effort is likely to be made to limit admitted capital shortfalls to levels that are curable by existing national resources and bail ins with minimal EZ collective assistance.

It can be assumed that political consequences of potential failures and declining market confidence will be avoided “at all costs.” 

In other words, the AQR stress test will not bring real transparency either to sovereign debt exposures or the real level of NPLs, derivatives exposures and other leveraged risks.

In short, the appearance of the dissipation of the Euro crisis is just that: appearance.  Fundamental problems remain to be dealt with and resolved.