THE US Federal Reserve took steps yesterday to make it easier for European banks to borrow and lend dollars. The Fed is now providing such cheap money to Europe that the European Central Bank can borrow from the Fed at lower interest rates than American banks. The Fed was joined in its efforts by 5 other major central banks: the Bank of England, the European Central Bank, the Bank of Japan, the Bank of Canada and the Swiss National Bank. The scope of the coordinated global effort gives you an idea of the enormity of the problem.
While the new world/old world solidarity is heart warming, the coordinated central bank action does nothing to address the underlying cause of the problem: European governments have too much debt. By providing cheap credit to Europe, the Fed aims to ease pressure on financial markets by increasing the supply of credit to households and businesses. Ironically, cheap money means lower interest rates and allows heavily indebted European governments to continue borrowing.
Even if Greece and Europe’s other credit junkies do not abuse the cheap money, pumping money into Europe may actually hurt Europe’s most vulnerable economies. How would this happen? Lending money to Europe means moving money into the Euro-zone which would increase the demand for Euros. A strong Euro would make goods produced in Europe more expensive compared with its trading partners. Expensive products are more difficult to export, and lower exports from Europe’s weak economies would lead to lower national incomes and less tax revenues. Embattled European governments that cannot raise enough tax revenue are likely to continue borrowing. They may have no choice.
Concerned well wishers hope that the supply of cheap credit allows Europe to buy itself time ahead of the scheduled intervention in Brussels on December 8. However, according to the Wall Street Journal, there are growing fears that Europe may not go to rehab before it is too late.
THE MARKETS have been temporarily buoyed amid optimism that European leaders will find a solution to the debt crisis. Unfortunately, the optimism is likely to be short lived because the problem with Greece is not just that they owe everyone a lot of money. Greek debt is a symptom of a more endemic problem rooted in the Greek culture.
Michael Lewis, writer for Vanity Fair, revealed the story of how Greece meandered towards its current nadir: tax evasion the norm, bribery a way of life, and the Vatopaidi monks obtaining a gift of Greek commercial property worth over a $1 billion.
His intriguing and insightful article, “Beware of Greeks Bearing Bonds“, uncovers the human story behind the Greek debt crisis. It is not a short piece, but if you have 15 minutes and are interested in the current affairs then it is well worth reading.
IN OCTOBER 2011, private banks accepted a 50% writedown on Greek debt. European leaders negotiated the writedown to avoid a technical default.
It is surprising that ratings agencies did not classify the writedown as a default when you consider that S&P defines sovereign default as “the failure to meet interest or principal payments on the due date…contained in the original terms of the rated obligation when issued”.
In your author’s opinion, the writedown of Greek debt falls clearly within the S&P definition of sovereign default.
Undeterred however by rating agency definitions, European leaders have characterised the writedown as a voluntary “private-sector involvement” or PSI. This is clever politicking because a “private-sector involvement” sounds like a positive development. However, in reality, it means that private investors have lost 50% of their investment in Greek bonds.
European leaders are now using the same brand of financial wizardry which created the global financial crisis in the first place. Over the last few decades, countless risky financial products were sold to investors using harmless sounding terms like “credit default swap”, “mortgage backed security”, “special purpose vehicle” and “off-balance sheet financing”.
Characterising the writedown of Greek debt as “private sector involvement” is more of the same financial manipulation, but it is also shrewd politics. European leaders know that a Greek default could have devastating consequences for the Euro-zone.
ON WEDNESDAY November 23rd, an auction of German government bonds (known as “Bunds”) managed to sell only €3.6 billion out of a total €6 billion worth of Bunds on offer (source: Economist).
Germany is one of the most financially stable countries in the Euro-zone, so its failure to sell all of its Bunds is worth examining. In the context of an ever worsening European sovereign debt crisis this could be cause for concern. However, there are three reasons why the news does not raise concerns about Germany. Firstly, the German Debt Agency (Finanzagentur) normally retains part of any new Bund offer, so a partial sale of Bunds is pretty standard. Secondly, German Bunds are expensive. With a current 10-year Bund yield of only 2.26% it is no wonder that investors have a weak appetite for German debt. Thirdly, European banks are currently focused on building their balance sheets not on lending. European banks have until the end of June 2012 to get their core capital ratios up to 9%.
While Bunds may still smell sweet, weak financial markets in Europe are a cause for concern.
Weak financial markets increase the risk that one or more European banks will fail. In fact, one already has. Dexia fell victim to the Euro-zone debt crisis in October and was rescued by Belgium and France. This is particularly concerning because only a few months ago Dexia was rated 12th safest bank in Europe by European Union stress tests. How could Dexia fail? The short answer is, surprisingly easily. Dexia has around $700 billion on its balance sheet, but like many banks it requires access to short term funding. With banks becoming increasingly nervous as a result of weak credit markets, Dexia simply failed to secure the short term funding it needed to stay afloat. Dexia’s problems stemmed in part from its exposure to around $25 billion of Greek debt.
There is every likelihood that Greece and other countries may default on their debts. Greece and Italy both have a debt/GDP ratio exceeding 100%, but they are by no means the only countries that need to balance their books. Debt levels are worryingly high in Japan, the UK, USA, Portugal, Ireland and Belgium (among others). Greece represents less than 2% of the EU economy, but the effect of a Greek default could be worse than the sub-prime mortgage crisis. There are three reasons for this:
Integrated financial markets: As we saw during the sub-prime crisis, credit markets are highly integrated. France alone is exposed to more than $56 billion of Greek debt (see graph below). If Greece defaults then this could drive a number of European banks into bankruptcy;
Nervous markets: As it is not clear which European banks may fail, nervous banks may stop lending money to each other. As a result, this would drive up interest rates or, in the worst case, may completely stop the flow of short term credit and put the viability of many banks and businesses in jeopardy;
The Domino Effect: Greece is the first domino. Following a Greek default, financial market vultures will turn their greedy attention to other beleaguered countries. Italy may be second in line.