Europe’s Reverse Alchemy in Full Throttle
Ratios sport a numerator and a denominator. If one wants to bring a ratio closer to a certain figure, it is possible to do it either by adjusting the numerator or the denominator (or, of course, both). Sometimes, grand failure results when the policy or decision maker adjusts one assuming falsely that the other will remain constant. [For example, in recessionary environments, governments trying to reduce the debt-toGDP ratio find that austerian attempts to shrink the numerator lead to faster diminution of the denominator (as the recession takes its toll), the result being a stubborn debt-to GDP ratio.] In the case of Europe’s banks, the repercussion of using the capitalisation ratio as the policy target is bound to be detrimental to the real economy. Bankers have already warned us: They will do all they can to avoid taking on new public capital. Which means, naturally, that (since the private sector will not give them any capital, courtesy of their parlous state), the only way they can achieve the 9% capitalisation ratio is by shrinking the… denominator. What does this mean? It means that they will try to sell their loans, their derivatives, their paper assets in general to whomever wants to buy. At the same time, they will avoid issuing of new loans like the plague (since loans increase the denominator). The effect of these moves will be massively to reduce liquidity in the marketplace at a time when the eurozone is entering a new recessionary phase. In short, if the Devil wanted to push Europe into a sea of even greater troubles, he could not have chosen a policy target (regarding the banking sector) better than that we find in the Brussels’ Agreement.
But there is more grief where the above came from: It appears once we delve into the means by which the 9% capitalisation ratio will be achieved. According to the Brussels Agreement, there will be three stages which must be completed by next summer. First, banks will be asked to seek more capital from private investors. [This is absurd, since no sensible private investor will ever invest in insolvent banks – unless they get a controlling stake that the current bankers will not want to part with.] Secondly, if the banks cannot secure private capital injections [which they will not!], then they must turn to their national governments for capital. And, thirdly, if the latter are bankrupt or fiscally strained themselves (as all of them are), the last port of call is the EFSF.
The problem with this process is twofold. First, in the hypothetical scenario that the bankers accept public money, even EFSF money, these sums will be added to the already strained public accounts of the relevant member-state. Yet another migration of the same problem that keeps toing and froing between the private and the public sector. Secondly, as mentioned before, bankers will fight tooth and nail to avoid public capital which will dilute their own control over the banks preferring instead to reduce their assets’ book. So, the three step process envisaged by the Brussels Agreement will give bankers the excuse they need to delay any talk of taking on new capital. In effect, they were given around ten months during which to shrink their loan and assets’ book while taking on only a minimum amount of public capital.
Verdict: The Brussels Agreement will lead banks to take steps which reduce liquidity, fan the fires of recession throughout an already euro-system and, crucially, prevent any serious re-capitalisation of our ailing banking sector.
The Agreement’s Second Aim: To revive comatose Greece
The centrepiece of the Brussels Agreement is, just like that of the 21st July Agreement, its proposed Greek rescue. Much of it centres around the 50% haircut of pre-May 2010 bonds that have not matured yet – and which have not already been bought by the ECB (which somehow places itself over and above other bondholders of Greek debt).
As we all know, Mrs Merkel burnt the midnight oil, with Mr Sarkozy and the bankers shop steward, a certain Mr Dallara, in negotiations the purpose of which were to lean on the latter to accept that the haircut be declared ‘voluntary’ (so as to prevent the triggering of the CDS’ issued in the past couple of years on Greek debt). Mrs Merkel’s negotiating strategy was simple: “Consent to a 50% haircut or take the blast of a full 100% insolvency.” Unsurprisingly, Mr Dallara relented.
There are a number of unresolved issues here but, nevertheless, we already know enough to reach a rather depressing verdict on the chances of the Greek economy even if the Brussels Agreement is implemented to the full and even if the accompanying (exuberant assumptions) are confirmed in practice. To cut a long story short, the agreed haircut will prove an insignificant relief for Greece (another case of too little too late) while the extra austerity that will be traded for it (and imposed on the new government in return for the haircut-loan package) will eat further into Greece’s GDP. In short, it is my estimate that, even if all goes according to the Brussels Agreement plan, Greece’s debt-to-GDP ratio will remain well above 140% by 2020 while the much needed GDP growth will be nowhere to be seen. Soon, perhaps within six months, another Crisis Summit will have to be convened to find yet another ‘final solution’ to the Greek debt debacle.
Ironically, the only reason why such a Summit may prove unnecessary is that the euro-system may have imploded for reasons to be found in its other constituent parts. But even under less dramatic circumstances, the Greek part of the Brussels Agreement will be neither here nor there if the other two planks (bank recapitalisation, see above, and the EFSF’s makeover, see below) fail. Just like the Greek part of the 21st July Agreement meant nothing once Italian and Spanish debt blew up, so with the Brussels Agreement the whole deal on Greece will be confined to the dustbin of history if something similar obtains in the banking sector, in the EFSF’s finances, in France’s triple-A rating, in Italy’s and Spain’s refinancing efforts etc.
But let’s, for argument’s sake, concentrate on the Greek situation alone, assuming that which we cannot, wisely, assume: that the other two parts of the Brussels Agreement hold together. What would the Greek haircut plus the new loans achieve? The official story is that it will shave off around €100 billion of the Greek outstanding debt. Sounds impressive? Yes, but wait. Things appear quite different upon closer scrutiny. For in order to entice Mr Dallara, Mrs Merkel threw in a ‘sweetener’, in the form of around €30 billion. Of this, €15 will be produced by the Greek state through privatisations [which with every day that goes by require flogging harder the dying horse of Greece’s public assets] and another €15 billion which will be borrowed by… Greece (from the EFSF). The sum of €30 billion will then be invested in the usual kitty of AAA-rated assets to be held aside as collateral (in case the Greek state fails to repay even the remaining 50% of the bonds’ value). In short, the haircut is going to reduce Greece’s public debt, at best, by €70 billion. That is an effective debt reduction of less than 19%, in terms of Greece’s debt-to-GDP ratio (the overall €380 billion outstanding debt will shrink, at best, to €310 billion while GDP, already down to €217 will have shrunk to €206 in 2012). In short, a pittance. Much ado about nothing. All this commotion, and the late night negotiations, in order to reduce Greece’s debt-to-GDP ratio to… 140%.