Daniel Lacalle

The Euro House of Cards and the Greek Temporary Relief

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After a week of maximum tension in Europe driven by the Greek elections, Spanish and Italian bond yields, and Cyprus, another one that needs a bailout, things seem to be stabilizing. As suspected, New Democracy -the conservatives- have won in Greece but they will need to form a coalition in the next 3 days. Germany have already suggested this may allow some loosening of program terms but Eurozone bond yields remain at historical highs and the challenges remain. Yet Greece solves nothing. At the close of this post (Monday 18th) Spain 10 year soared to 7.00%, a spread to the Bund of 553bps.The solution to the debt crisis in Europe is evident. No more reckless spending, reduce debt and avoid forcing monetary expansion measures. After consuming billions of dollars in expansionary policies without success, Europe should stop and think that the damage is greater than the benefit. All these mechanisms have proven ineffective . We have seen five consecutive years of stimulus plans in Europe, a total of $2.63 trillion, with no evidence of success. Providing liquidity and financial relief must be temporary measures, not structural. To demand half a trillion in new stimulus each year is madness.

The solution is fiscal prudence, halting the spiral of political spending, cleaning banks’ balance sheets-preferably paid by shareholders and bondholders-, attracting capital and eliminating unproductive subsidies.

The European House of Cards

The European crisis continues and this page ” The European Super Highway of Debt “ shows visually the size of the house of cards. More debt is not going to help.

In the European credit market we have seen this week a few interesting things:

  • Despite the austerity measures, Spanish public debt has grown 5.39% in the first quarter to 774.5 billion euros, 72.1% of GDP. Reforms must continue, but much faster.
  • The Spanish risk premium to the Bund stands at 553 basis points . Why? Because debt and financing costs would soar if the country was to use the loan of 100 billion to recapitalize the troubled banks, making it more difficult to repay that debt. The key issue to tackle is that international investors are selling government bonds, leading to the Spanish banks having to buy more public debt. Almost 67% of the country’s debt is now in national hands.
  • The credit default swaps (CDS) in France and Germany are up almost 12% in a month, showing that the crisis is still spreading. All CDS, including Germany’s, have risen on the risk of another stimulus plan/shot of debt. This is what happens when one breaks the principle of responsibility of creditors. Structurally rescuing banks and countries endangers the whole system.
  • The International Monetary Fund on Friday urged Europe to help Ireland refinance its crippling bank bailout and consider taking equity in state-owned banks to help Dublin return to bond markets and avoid a second bailout next year.
  • We are told again and again that the ECB and Germany do not support peripherals . However, the numbers say otherwise. The Bundesbank has lent to the periphery of Europe 699 billion euro since January within the Target scheme II, equivalent to almost 25% of the GDP of Germany. Spanish banks have asked the ECB for a further 7.4 billion euros, making a total of 288 billion so far.
  • While Europe, the ECB, EFSF or ESM, provides support, the countries contributing funds to these institutions are almost all highly indebted and are funded in many cases at much higher rates. Il Corriere della Sera echoed the irony that Italy will contribute 19 billion euro to the 100bn loan to Spain, lending it at a 3.3% rate when Italy has to borrow in the markets at 6%.

Look at the chart below. Over 85% of the money that is contributed to the European stability fund is provided by heavily indebted countries and their contribution is not capital. It is debt.

The Greek Relief

In all this week heading into the Greek elections we have read comments that central banks “maybe” “may” “study” the “possibility” of a concerted action to support the economy. Failed before? Try and try again.

Greece shows us the fragility of Europe’s policy of “debt with more debt.” Greece is not the problem, it is part of it, but it can cause a big financial turmoil given the web of cross-country loans.For starters, Greece will need a new additional injection of 15 billion within weeks. Remember in April 2010 when former Spanish president said that the country would gain about 110 million euros a year -yes, a year-with the loan to Greece? Now, neither loan nor gain. A donation.

To put it simply:

New Democracy winning, with a coalition of pro-Europe parties, solves nothing. It is ironic to see the markets rejoice at the fact that the same party that lied about the countries’ finances is now winning. Greece will probably renegotiate the terms of the bailout, yet require a package of “growth”- ie debt- for infrastructure projects financed by the EIB. Funded is probably too big a word, because it is highly unlikely that the loan will be repaid. The “cost” of this option is estimated at 50 to 60 billion Euro in a period of 18 months. JP Morgan estimates only €15bn of €410bn total “aid” to Greece went into economy – rest to creditors, yet the financial hole of lending to Greece has only grown.

The reality is that no matter who ends in government, in Greece what has won is the scheme of a hypertrophied state, political spending and cronyism between government and financial institutions. And that additional debt will be funded by a Euro-zone with fewer resources and increasingly isolated from international markets.

The giant financial web, the house of cards of the Euro-zone, is the reason why every time there is an announcement of intervention the placebo effect lasts a few hours an bond yields explode higher. The  house of cards of debt is the root of the problem and only tackling it would be the beginning of the solution

At the close of this article, there is speculation again with the possibility of a massive shot of liquidity (LTRO) from the European Central Bank, but this has a considerable risk. Banks use most of that liquidity to buy sovereign debt, creating a vicious circle. On the one hand, liquidity does not reach the real economy, lending to households and businesses continues to fall, and on the other hand, it doubles the risk. The bank balance sheet risk and the public debt risk together. This is because banks have ​​it more difficult to attract funding as their sovereign bond portfolio gets larger and riskier, impairing financial entities’ balance sheets.

The stubbornness of the European Union to solve a debt problem with more debt only increases the fragility of this house of cards. Fortunately, now there is no turning back because the creditworthiness and the credibility damage is already done. Now, the entire European Union must address the shortcomings of its foundation and find a real fiscal union and implement credible fiscal prudence. Only then, and not before, will Europe see international capital returning and see sustainable economic growth.

You can watch my interview in Al Jazeera on the Spanish crisis here
http://www.aljazeera.com/programmes/insidestory/2012/06/20126126534386935.html

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