Shelter from the storm?

I was burned out from exhaustion, buried in the hail

Poisoned in the bushes an blown out on the trail

Hunted like a crocodile, ravaged in the corn

“Come in” she said, “I’ll give you shelter from the storm”

Bob Dylan

It is now clear what the Schlieffen Merkel game-plan is – and that she has Sarkozy under her thumb in pursuing it. It is to support Greece to the hilt in the present shambles. The Greeks will get their €8bn – and soon. There will be no more quibbles or threats from the troika or any of its components and nor will there be, to the best of her ability, any more rude noises from her ministers. The next tranche will be handed over despite the fact that Greece is not currently meeting – and will not and cannot meet – the targets laid down in the memorandum of understanding and work-out plan agreed with the troika.  If there is any doubting that the French have been brought to heel by Merkel, then simply look at the utterances of French government spokeswoman and budget minister Valerie Pecresse Sunday 11 September, that France would stop lending to Greece if it did not deliver on its part of the bailout program.

The plan has two aspects; aid to Greece with the guarantees, but also a Greek recovery plan. They have a privatization program, a spending-cut program, a program for taxing revenues. Greece must make efforts, otherwise we won’t lend to them.

And then look at the same Ms Pecresse’s Wednesday 14 September statement:

We must implement this plan in its integrity, with all its counterparts, and this will be the object of the discussions that the president, Chancellor Angela Merkel and the Greek prime minister will have today,” … The accord of July 21st, all of it, and as quickly as possible.

What did Harold Wilson once say? Well didn’t he get it wrong!

There is a very simple reason for all of this panic: anything less than such a course of action will lead to a disorderly default by Greece; the crystalisation of the generalised European banking crisis; and a truly existential moment for the euro – and thus for the entire global financial system.  Obama, already into his re-election campaign, has also pleaded with her and has sent Tim Geithner to Europe to ensure that everybody is on message. Geithner will be in attendance at euroarea (EA) finance ministers and central bankers’ meetings in Poland this coming weekend and his message will be ‘get on with it’. Geithner’s attendance is almost but not quite unprecedented: he was according to the late Brian Lenihan, in on the key conference call of finance ministers that decided terms for the Irish bail-out. According to Lenihan it was Geithner who demanded that there be no burning of bondholders.

This is not to say that the Greeks have got off scot-free, not at all. The austerity programme must proceed – and in its enhanced form.  The new temporary property tax will be implemented and the enormous and accelerated shrinking of public sector employment and the cutting of public servants’ wages will continue. All of this will proceed under European Commission supervision – the special team reporting to Olli Rehn that arrived in Athens this week.

Will Greece default? Actually it already has in a sense in including its private sector involvement (PSI) formula in its rescheduling or exchange or rollover of securities – and so far in an orderly fashion although the process may at the point of exchange of old bonds for new trigger a short-term credit event or temporary ‘ratings default’. The PSI amounts to a ‘voluntary’ acceptance by bondholders of a 20 per cent haircut. While the acceptances have so far fallen short of target the scheme will proceed and acceptances are now likely to increase (under voluntary pressure one might say). Look also at Greek yields – if only for some light entertainment (and evidence that for the markets, Greece no longer exists – and that will remain the story for many years to come). The GGGB1yr yield is now in the range 140 – 150 per cent and equally, longer maturities are also out of the question with 3yr yields north of 170 per cent: the markets have closed to Greece. The Merkel project is to collectively holdout against the markets and push the big ‘D’ moment out to 2013 when the ESF with its bailing-in provisions comes into force.

All of Merkel’s effort, including in relation to Greece, is to stave off a catastrophic European banking collapse that would not at all be confined to the EA and would contaminate Germany. It would also most certainly extend to embrace the British banking system – and thus to the US and Asia. That same European banking collapse would further lead to the downgrade of the French sovereign (as well as Italy, Spain and Belgium). That Europe is in the grip of such a scale of banking crisis despite repeated denials is clear from for example the statement of the CEO of Swedbank Michael Wolf this morning on the announcement of that bank’s share buyback was being suspended:

During the past weeks, the situation in Europe has worsened significantly. We see today no altered risk in our portfolio, but the perception of our buyback program is not supporting Swedbank’s brand in the current market situation. On my recommendation the Board have decided to halt further repurchases until the market situation becomes clearer.

Further, according to the Swedbank statement,

We believe that regulators have been increasingly concerned around the developments in continental Europe and there has been growing concern that continuing buybacks is not prudent. While the buyback programme has not affected Swedbank’s funding, Swedbank has chosen to act conservatively and postpone the buyback programme. The resumption of the buybacks is now contingent on how the macro-political environment in continental Europe develops.

However much rating agencies have attracted buckets of ordure post sub-prime, the MBS fiasco and the rest of Paul McCully’s alphabet soup of disasters, Ponzis and other frauds they do have a point in making calls such as that of Moody’s in relation to SocGen, Credit Agricole and BNP Paribas on Wednesday (September 14).

The Merkel plan is also aimed at nipping in the bud the Spanish and Italian sovereign crises. And let there be no doubt but that Spain and most particularly Italy are in the grip of sovereign crises.  The Italians had a disastrous auction experience Tuesday. A €7bn fundraiser fell short with comparable yield up and demand down.  The target was €7bn and outturn€ 6.5bn.  Yield on the 5yr bond was 5.6 per cent, up from 4.93 on the 14 July auction. Demand was 1.28 times amount on offer against 1.93 on the last tender.  Yield on the 10yr rose 16bps to 5.731 per cent and a spread of 398bps over bunds. Simply put per Bloomberg,

Investors have dumped Italian debt as divisions among European governments over how best to fight the region’s debt crisis sparked concern the contagion would spread to the bloc’s third-biggest economy. Bonds have dropped even after the government passed a 54 billion-euro austerity plan that failed to ease concerns that weak growth would lead to a credit rating downgrade and hurt efforts to cut Europe’s second-biggest debt.

While on Wednesday there was a recovery in Italian (and Spanish) bonds it was essentially the outcome of ECB interventions. Again per Bloomberg,

Spain’s bonds advanced amid speculation the ECB will buy more of the securities after it started purchasing Italian and Spanish debt on Aug. 8.

Ten-year Italian yields fell five basis points to 5.66 percent as of 10:39 a.m. in London. Earlier they climbed as much as six basis points to 5.77 percent. The 4.75 percent security due in September 2021 rose 0.375, or 3.75 euros per 1,000 euro face amount, to 93.720. Two-year yields fell five basis points to 4.60 percent.

There is also another factor: for starters Italy must dump Berlusconi – a must for markets, even before austerity.

A third element in the Merkel plan is the ratification by all MS of the Treaty establishing the European Stability Mechanism (ESM). The ruling Thursday of last week by the German Constitutional Court sufficiently in her favour to have it adopted by the Bundestag, scheduled for 29 September, enables its adoption by Germany. There remains downside on this front though: others also may require to be pushed into the starting stalls – Austria, Slovakia for example.

Also relevant to the situation is the ECB decision to return Wednesday to handing out dollar funds to a banking system starved of the US currency as a result of the effective withdrawal of the US money market funds from the short end of the EU funding scene. Ignore BNP Paribas haute dudgeon over the WSJ piece Tuesday quoting an unnamed insider “Since we don’t have access to dollars anymore, we’re creating a market in euros. This is a first. . . . we hope it will work, otherwise the downward spiral will be hell. We will no longer be trusted at all and no one will lend to us anymore.” Ignore the 12 per cent fall in the BNP share price and ignore also how questionable the whole Journal column might be said to be. European banks are mired in at least a liquidity crisis. At the short end of the market Europe’s banks simply cannot source dollars on other than prohibitive terms if at all. Thus per Dow Jones out of Frankfurt, step forward the ECB, using the ECB/Fed swap arrangement

The European Central Bank said Wednesday that it allotted $575 million at its seven-day dollar term auction, marking only the second time in six months that it has handed out dollar funds amid renewed tensions in euro-zone money markets.
Two banks requested dollar liquidity against ECB-eligible collateral at a fixed rate of 1.1%, the data showed.

Will all of this – giving Greece the cash; putting a floor under Spanish and Italian bonds; proceeding with the ESM treaty; and ECB operations do the trick? Will kicking the can down the road one more time as opposed to facing into deep constitutional change (Buiter’s fiscal federalism or fiscal union) stave off a European Lehman moment and possible EA disintegration (not to mention large-scale nationalisation and public recapitalisation of the banking system with consequent abandonment of debt and deficit targets as well as bank liquidations along the way)? Is Merkel welcomingly offering us “shelter from the storm”?

Well that depends – on whether her door really is open and even if so whether her plan can, while involving taking some damage and loss, still withstand the storm and sustain two years of dyke-plugging.

In a recent research note Citi’s Willem Buiter and Ebrahim Rahbari do see Europe coming through. Thus while both elected policymakers and the ECB “are likely to continue to disappoint repeatedly” – surely accurate – the EA still has “the institutional and political capacity to deal eventually with the current crisis and to make the necessary reforms to ensure its long term survival.” Ever the optimists surely.

On the other hand there is David Zervos at Jefferies & Co as reported by ZH. Zervos sees the troubled European sovereigns as no different to US sub-prime borrowers: In both cases loans were made to folks that never had the means to pay them back.” However there are only a handful of insolvent sovereigns while there are millions of bankrupt subprime households. But there are also lots of insolvent banks with sovereigns on the hook for their survival on the good ol’ TBTF formula. Sovereigns and insolvent banks must be disentangled. Expect large-scale dislocation though in sorting out the severing the umbilicald between sovereigns (sunk or otherwise) and insolvent banks. On the Zervos view governments will take charge and “Europe as a whole is about to embark on a sloppy financial market socialization process that has been held back for nearly 2 years by 3 bailouts. The weak links will not be able to raise enough Euros/wipe out enough private sector equity to get this done, so there will be EMU members that need to exit and use a reintroduced currency for this process.” Further, there is a reason why “German CDS is 90bps and USA CDS is 50bps – Bunds are not a safe haven in this world – and there is no place in Europe that will be immune from this dislocation.” Oh dear!

Zervos and Buiter and Rahbari though are not exactly polar opposites either. Zervos sees destruction leading to collapse of the EA while Buiter and Rahbari see large scale destruction but sufficient systemic resilience to ensure survival – even in the absence of fiscal union and in the face of “near-inevitable debt restructurings of insolvent EA sovereigns and EU banks.” One critical difference between the two scenarios is that Zervos does largely see the crisis working out and being worked through, driven by national initiatives – the result of German insistence that it is not going to be the community lifeboat. Buiter and Rahbari on the other hand see EU and EA institutions being central to the management of the crisis – if in a hesitant, higgledy-piggledy way. It will not be pretty: banks will fail and sovereigns default (note the plural: Greece certainly and Portugal and Ireland most likely). While the institutions will continue to disappoint they will also innovate sufficiently – under duress of course – to have the EA (and EU) stagger over the line. Critically they will manage to build into the ESM a sovereign debt restructuring mechanism (SDRM) and a pan-European special resolution regime (SRR) for banking. All within 18 months or thereabouts? And somehow also escaping confronting the elephant, per George Magnus,

“The dilemma over where to draw the lines between integration and sovereignty lies at the core of the fiscal union debate. The policy agenda has to recognise this, and not assume that fiscal union, one way or another, is eventually a ‘gimme’, even though logic would say it should be. Parallel to the logic are the politics and vested interests, the German Constitutional Court notwithstanding, which say fiscal union only one theoretical outcome, and maybe a long shot. Most likely, the political limits to fiscal integration have not yet been reached, but if there are further moves towards but not reaching this goal, they will most certainly be on German, and therefore, limited, terms. We may conclude that while the Euro system is not about to break up, its viability as it stands is far from assured.”

That puts it mildly as the British sue the ECB; Finns demand collateral from the Greeks giving others ideas; the Germans insist on minimalism; economic nationalism remains a powerful force politically in Member States; Berlusconi seems immovable; the Commission continues intellectually moribund, incapable of offering leadership; and intergovernmentalism and Franco-German hegemony are in the ascendant. It is a tortuous process, time-consuming and degenerative of the most turgid prose and mindless Eurospeak, fine in benign sailing conditions but only then. Otherwise a sure recipe for protraction, fudge and inch-by-inch movement – paint drying policy at best.  Further, the IMF’s attempt to have an SDRM agreed ended in failure while a pan-Union SRR to succeed must surmount bristling legal difficulties and markedly different legal traditions.

Bees don’t have the aerodynamics for flight – but they fly. A fanciful analogy? Yes, and Merkel is by now seriously wounded. There is also something else: the fire currently raging must be put out, it cannot be let simply burn out. In the end to quote Martin Wolf’s recent conclusion, in his FT column

In the end Germany must choose between a eurozone disturbingly different from the larger Germany it expected or no eurozone at all. I recognise how much its leaders and people must hate having been forced into a position in which they have to make this choice. But it is the one they confront. Chancellor Angela Merkel must now dare to make that choice, clearly and openly.            

Amen.

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