Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Monday, 3 September 2012

What does September bode? Part - II



2. Draghi will save us

Summary:

Any ECB action will require the imposition of strict conditionality. It may also require ESM/EFSF acting in concert. There is opposition both to ECB action and to acceptance of strict conditions. Moreover there are the usual political disagreements on EFSF/ESM role and deployment.

As politicians fiddle and squabble over everything economic conditions continue to deteriorate in the Eurozone. The malaise is no longer confined to the peripherals. France has been moribund for a long time and now Germany’s economy is heading south as well. In addition, optimistic growth, revenue, budget and deficit targets for bailed out countries were missed as usual. Lack of a solution has spooked the private sector and European banks are pulling back into their own territories. A solution requires more than printing money. 

Facts and Analysis:

  1. Draghi’s promise of quasi-monetisation came with strings attached but was conveniently ignored by the market. He stated (emphasis mine), “In order to create the fundamental conditions for such risk premia to disappear…governments must stand ready to activate the EFSF/ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist – with strict and effective conditionality in line with the established guidelines. The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions. The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed.”
  2. There is considerable disquiet in the Bundesbank over Draghi’s policy with reports that Jens Weidmann considered resigning over the issue.
  3. There is opposition from Germany to granting ESM a banking license. This severely limits the firepower which can be deployed for bond market purchases. Without a banking license the brunt of bond buying will fall on the ECB deepening the schism between easy and hard money camps.
  4. Showing that in Europe what is agreed is not really agreed, EU banking supervision plan has hit resistance with Brussels pushing for ECB to regulate all banks against German and ECB’s own opposition.
  5. Pan-European supervision may be moot as the nationalisation of the banking sector continues apace. Northern banks continue to withdraw from the periphery and peripheral banks become more exposed to the home country.
  6. Amidst the talk, the economic situation across Europe continues to deteriorate. The two biggest economies are foundering.
    1. Germany: “German private sector output falls at a faster rate during August. Renewed services contraction offsets slower drop in manufacturing activity.
Source: Markit 

    1. France:
      1. PMIs have improved but are still stuck in contractionary territory. Employment is still trending down. (Graphs below)
      2. Banking troubles aren't over as CIF becomes the latest recipient of government bailout.
Source: Markit

Source: Markit 

  1. Decline in peripherals proceeds unabated.
    1. Spain:
      1. The regions are lining up for federal bailouts. After Catalonia’s €5bnValencia is poised to ask for €4.5bn (higher than previously expected €3.5bn). Apparently Andalusia is also lining up.
      2. Banking is not fixed as shown by Bankia’s €4.4bn loss released on late Friday evening (convenient timing). NPL’s jumped up and client deposits fled.
      3. As flames rise higher, Rajoy is still hoping for a “condition-lite” ECB intervention. This is despite Asmussen stating that any ECB help must come with strict conditionality and ECB must not repeat the bond buying “mistakes” with Italy last year.
      4. Amidst the political brinkmanship deposits are fleeing the Spanish banking system. ECB data showed a drop of €74.2bn in private-sector deposits in the Spanish banking system. The biggest decline since the series began in 1997.
      5. Economic decline continues with the latest manufacturing PMI showing that output fell for the 16th successive month.
    1. Greece:
      1. The economy continues to head south. GDP contracted by 6.5% annualised in Q2 making IMF-EU assumptions of 4.7% contraction look positively rosy. Unemployment is at a record 23.1% with 55% youth unemployment.
      2. The government has yet to agree to the details of the budget plan. The quote from Venizelos says it all, “We didn't get into details about the austerity measures. This will be done by parties' representatives during the following days, and then there will be another political leaders' meeting.”
      3. More time for the meetings may not be forthcoming. Merkel was non-committal on Samaras’ pleas of more time to implement cuts. However, other German politicians were not as obliging. Volker Kauder, Merkel’s party’s parliamentary leader stated that “neither thetime nor the content can be renegotiated” and Schauble refused to “throw money into a bottomless pit”.
      4. Public opinion in Germany is increasingly anti-Greece. Nearly half the respondents in the latest poll believe that Greece will never be able to reform its economy to free itself from international assistance.
    1. Portugal
      1. Away from the limelight, Portugal is seeing austerity work its magic. Tax revenue dropped 3.5%. Laughably the IMF/EU expectation was for a 2.6% increase.
      2. Budget deficit for 2012 at 5.3% is expected to miss troika target of 4.5%. But it is not a problem as the troika has indicated that it will relax the target in light of a better than expected reduction in external deficit.
      3. Unemployment has increased to a record 15%.
    1. Cyprus: Budget deficit is going to be 4.5% as opposed to the forecast of 3.5%.
    1. Ireland:  Schauble poured cold water over Irish hopes of palming off their bank debt guarantees to the EFSF/ESM. But the Irish economic engine is the one bright spot in peripheral land with its slow grind towards recovery. Whether it can sustain is another question.
    1. Italy
      1. GDP contracted by 0.7% for the fourth successive quarter. The good news was that it beat expectations of a 0.8% decline.
      2. Latest manufacturing PMI (September) was the lowest since October 2011. It showed employment and new orders falling faster.
      3. Italian politics is reverting to normal as elections loom in the first half of next year.
  1. To underscore that the ‘Germany vs the rest’ narrative is facile and wrong, Netherlands is following Finland into increasing Euroscepticism.
    1. Dutch elections are likely to deliver a government unsympathetic of bailouts. The socialists under Emile Roemer have gained in popularity and are expected to win or come second in the election. Unlike the international solidarity of the Comintern, they want to stop bailouts and use that money for the Dutch. Incidentally, they voted against the bailouts of Spain and Greece and the ESM.
    2. Dutch manufacturing PMI rose in August but still remains in contraction territory at 49.7. Importantly output and employment continued to fall. This is not an economy where citizens will appreciate largesse to indebted peripherals.
Verdict:

An entire battalion of tanks is slowly moving towards Draghi, the lone bazooka gunner on the hill. Even as he tries to take aim, he is being peppered by shots from his own side. Since this is not a Hollywood movie, the chances of Draghi unilaterally saving the Eurozone are slim. Moreover, the expectations raised by Draghi's fighting talk may be disappointed. 
Sovereign defaults may be avoided by the expedient of short-term/T-bill issuance repoed with ECB (a path blazed by the Greeks) but the Euro rally is unlikely to last for much longer. Short-term bonds and CDS spreads may benefit due to intervention but long dated bonds are an iffy investment. 

Continue to Part - III

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