Judgement Day for the ECB, as Spain Ponders a Bailout…

Nobody would confuse the self-effacing Mario Draghi with Arnold Schwarzenegger, and the title of the ECB’s movie would be Target 2 rather than Terminator 2, but this week’s meeting will be a blockbuster event for markets, which have anticipated a bond buying spree by pushing 2-yr Spanish and Italian yields to multi-month lows and to the lowest ever relative to local 10-year bonds. The key to ‘surprise’ policy developments since June is that the euro zone payments system has been operating as an implicit bailout mechanism. I highlighted this back in the June 7th  note, when I wrote that: ‘The most dangerous trend in the euro zone is that financial institutions are increasingly trying to match assets and liabilities by country, defeating the original purpose of EMU in fostering integrated and more efficient cross-border capital markets, while a rising share of cross-border risk is now assumed by the ECB and de facto by the Bundesbank.’ If the ECB collapsed in a euro zone break-up, the biggest loser via both the financial and trade impact is Germany. The reluctance to abandon Greece stems from the fact that if it departs from the euro zone or if its Target 2 balances are capped, the current slow bank run from the periphery would accelerate uncontrollably, unless the other peripheral nations were backstopped explicitly by the ECB, which is where things are heading.

After a brief respite in sovereign funding costs for Italy and Spain following nearly €1 trillion in LTRO (long-term refinancing operation) lending to euro zone banks by the ECB at the turn of the year, in Q2 these rates rebounded as Spain in particular had to revise its fiscal target for the year and concern mounted about its banking clean-up costs, with many commentators fearing a possible debt restructuring for Spain. Interest rates on 10-year bonds had fallen from peaks of 7.3% for Italy and 6.7% for Spain in late November 2011 to lows of 4.9% for both countries at the beginning of March 2012. By the third week in July, however, these rates had rebounded to 6.6% for Italy and 7.6% for Spain. The EU summit at the end of July agreed in principle on a banking union that could potentially relieve the Spanish sovereign of those bank bailout costs, and the ECB pledged forceful ECB support for two-year bonds subject to policy conditionality. These have been very positive developments, but ultimately, the prospects for avoiding debt restructuring in the two economies will depend on whether economic fundamentals enable them to boost solvency dynamics with a higher nominal growth trend.

This intra euro zone payments system was the critical issue driving my expectation in Q2 of a German compromise this summer; before the current crisis, these balances more or less offset each other or were settled through the private interbank market, which has ceased functioning. As a consequence, large positive Target 2 balances have arisen with the national central banks in the four northern Eurozone countries (Germany, the Netherlands, Luxembourg, and Finland) and corresponding big negative balances with eight countries (Italy, Spain, Ireland, Greece, France, Portugal, Belgium, and Austria). The causes of these balances are current-account deficits of the southern countries as well as transfers of bank deposits from the south to the north. Germany’s surplus alone corresponds to about a third of its GDP.

While Spain looks set to turn to the EFSF for a formal bailout subject to stringent conditionality in order for the ECB to buy its bonds, Italy’s situation remains more benign. There was no real estate bubble in Italy; Italian banks are weakened by recession but their balance sheets do not bear the legacy of mortgage NPLs. At 123% of GDP, public debt is clearly high, but the government runs a primary surplus (3.4% of GDP this year) while Spain has a primary deficit of 3.3%. Italy’s net external position is balanced while Spain has run current account deficits close to 10% of GDP per year over a decade. If Italians were to swap their foreign assets with the government bonds held abroad, Italy would look like Japan: a highly indebted country at the sovereign level but one in which a private funding surplus means the vast bulk of that debt is held domestically.

In part this ‘domestication’ of Italy’s outstanding debt has already happened as a result of the ECB’s LTROs. The share of government debt held by foreign residents has fallen since late 2011 from 45% to 34% of the total. Italy’s technocratic government owes its legitimacy to its ability to steer the country through this crisis, which would vanish if a formal bailout were requested. If that happened, an early election would be inevitable with the likely result being a hung Parliament, probably dominated by a resurgent Berlusconi. As things stand, a general election is due in the spring of 2013 and parliament needs the intervening period to pass a new electoral law that should reduce the probability of a hung Parliament.

The day (later this month?) that Spain goes to the EFSF and the ECB starts buying its bonds, Italian bonds will be under renewed pressure. Without a bailout, Italy will need to reduce the volume of medium- and long-term bonds it auctions from now until the general election because yields will not fall until the political uncertainty is resolved. Some €100 billion of these will come due in the next six months; rather than rolling them over, they should be redeemed through the future revenue from asset sales.  The government still owns large shares  in publicly traded companies, among them Enel, Eni and Finmeccanica. There is also a huge stock of prime real estate, harder to sell outright near-term but feasible to mortgage/ securitise to raise cash.

If a credible program of asset sales is launched in Q4, bridge financing could be also provided by the Cassa Depositi e Prestiti, a government-controlled institution which finances itself through saving deposits issued by the Post Office worth €220 billion. The Cassa lends to local authorities and these loans are accepted by the ECB as eligible collateral. They could be turned into liquidity that the Cassa could use either to buy government bonds or to lend directly to the Treasury. None of this would solve Italy’s underlying trend growth and productivity problems, but it would give the country a period of relative calm which Monti could use to give new impetus to his government.

Meantime,  the  euro  zone  economic  data  continues  to  disappoint,  although  the  pace  of deterioration has abated; the euro area manufacturing PMI was revised slightly down in August, to 45.1 from the flash estimate at 45.3. The revision was driven by similar moves in Germany (to 44.7 from the flash at 45.1) and in France and by mixed releases in the periphery. In the latter, manufacturing PMIs remain well into negative territory and consistent with a sharp contraction in activity. The Italian manufacturing PMI fell to its lowest level since October 2011, to 43.6 from 44.3 and has failed to improve from the lows recorded in Q2. The Spanish manufacturing PMI, on the other hand, rose to its highest level in 6 months, up to 44.0 from 42.3. The rise was mainly driven by new orders, up to 43.1 from 39.2 (export orders up to 48.2 from 44.2, its strongest reading since Aug last year). Employment also moved up a bit, to 42 from 41.5. In Ireland, the PMI index fell in August, but it is the only one still above 50, at 50.9 from 53.9.

Will the current plan work as outlined? In principle, the ECB can eliminate ‘convertibility’ risk (i.e. risk premia associated with investor fears of an EMU break-up) in peripheral debt markets by acting as lender of last resort and capping yields at a level that ensures solvency. The ‘target’ yield would need to be sufficiently low to be consistent with debt sustainability but sufficiently high to maintain the incentives to undertake domestic reforms. This would theoretically eliminate (or at least reduce massively) the risk of default and start a virtuous cycle. However, in order to be ‘successful’, the ECB would need to be credible that it is going to defend its desired target rate. Clearly, the ECB has the balance sheet to buy as much debt as needed to defend the target yield it pleases. But in practice, the ECB is unlikely to commit to the magnitude of the intervention that may be required to cap yields because of concerns that moral hazard in policymaking could lead the weakest countries in the Eurozone to slacken their efforts to reduce structural deficits and the ECB may not be willing to accept the associated credit risk.

Instead,  in  conjunction  with  the  EFSF,  it  is  going  to  provide  limited  conditional (and potentially sterilised) lending. This raises the issue of subordination. Mario Draghi commented that “private investors’ concerns about seniority will be addressed”. Despite these assurances, investors cannot rule out the possibility that in an eventual restructuring, the ECB would claim seniority regardless; Draghi is almost certainly unable from a legal standpoint to renounce irrevocably the institution’s seniority in a credit event. The second problem is that limited and conditional ECB/EFSF intervention may not reduce yields sufficiently, because the ECB is unwilling to make purchases unconditional on the underlying fiscal position. Spain and Italy face credit risk compounded by the fact that while ECB lending may or may not be unlimited it is conditional, so bond investors have to assign some probability to a scenario in which the ECB bond buying is curtailed because of missed fiscal targets.

The new plan certainly increases the chances of eventual resolution of the crisis as an interim step toward eventual fiscal union/common bond issuance. Success over the next 6-12mths should be measured in the ability of Italy and Spain to regain market confidence such that longer duration (5-yr plus) yields start falling on a sustained basis as private sector buyers return. Given the conditionality, if domestic political support for further adjustment evaporates in say Spain, the end game will still be either default or debt mutualisation, either of which will be traumatic for a different group of investors. The flurry of policy initiatives since June should be welcomed as providing an overdue respite from the euro zone solvency crisis allowing global investors to focus on asset fundamentals and other macro risks from China’s painful post-stimulus deleveraging to the US debt ceiling, but no more than that.

Europe Exceeds Low Expectations…

The clearest result from the latest EU summit was that EFSF/ESM funds can be used directly to support banks, a positive move toward breaking the destabilising bank/sovereign linkage which was exacerbated by the ECB’s LTROs.  However, that can’t happen until we have a new pan euro zone regulator in place, and in the interim the ECB will have to step in via a longer duration LTRO or SMP peripheral debt purchases. I moved in the strategy note in mid-June to add portfolio beta and on my recent Asian tour, it was clear that expectations were extremely low, and well managed by euro zone politicians for once. The sharp risk rally in recent days partly reflected short-covering, but there are as ever plenty of loose ends in this deal. The new agreement implies that in the future, banks will be bailed out by the collective effort of euro zone countries. At the very least, disintegration has been postponed a while longer, although true fiscal union via Eurobonds etc will have to wait until after the September 2013 German election.

Germany’s position had softened in the run-up to the summit, from seemingly ruling out any further help for Italy or Spain to insisting that any assistance must be through the tools already in place, a shift that investors largely ignored. However, Germany remains adamant that new aid requires more conditions and EU oversight. The plummeting yield on Irish sovereign debt was significant as the burden of its banking rescue looks set to be lifted alongside action on Spain, allowing a return to the bond markets in 2013, and indeed the country is set to return to the bill market this week with a €500m sale. Whether the rescue fund will be used to buy Italian bonds is still unclear, and we have 1.6trn in Spanish and Italian bonds to absorb between now and end 2014, which requires either a dramatic resurgence in private sector appetite or an unprecedented scale of ECB purchases. The key is to cap peripheral yields at a level which private sector investors perceive as sustainable and therefore an attractive entry level, probably about 4-4.5% for Italy and Spain.

While the move on seniority for official capital injections from the ESM will comfort private investors, senior bondholders are ultimately very likely to be made to absorb losses for the first time in this on-going crisis; the numbers simply don’t add up otherwise, given total EFSF/ESM resources of only 500bn, and no leverage to be applied to these funds apparently. The direct capital injection arrangement is linked to the establishment of a “single supervisory mechanism involving the ECB”.  This could be a single regulator inside the ECB (similar to the new UK model), which would go a long way to correcting the absence of a joint regulation and restitution regime for banks. The point of having a single supervisor trusted/ controlled by the ECB is to make it possible for the ECB to at long last act as a lender of last resort, and that’s the most bullish implication of the whole deal. The summit also agreed on a growth pact adding up to a total of some 1% of EU GDP via a ragbag of initiatives (SMEs, energy and broadband infrastructure etc.) that will do little to boost trend growth but is a sop to the new French President.

Overall, despite a host of details such as the timescale for the new bank regulator to appear (and the equity injections require that oversight in place, which is unlikely before next year), this was a milestone next step toward a fiscally integrated euro zone. A grand European bargain between Germany and other euro members is taking shape, requiring countries to give up a large degree of sovereignty over their budgets. While Berlin continues to insist that European leaders take concrete steps toward a fiscal union, Germany is open to a level of mutual financial support between euro members that has so far been taboo, so long as joint EU fiscal policy comes before joint debt liability. Italy and Spain will have an easier time qualifying for aid from the ESM; countries that comply with existing economic-policy recommendations will be eligible for aid without having to fulfil any extra conditions.

That’s less onerous than the conditions which Greece, Portugal, and Ireland had to meet to get bailouts. By until now claiming preferred status, official lenders have effectively subordinated private bondholders, driving private bondholders to demand even higher yields as compensation. However, for now, at least, official lenders like the ESM will still have preferred creditor status on loans to countries other than Spain. The ECB is likely to follow through on the summit progress with a rate cut this week of at least 25bps, and a longer dated LTRO scheme is likely soon. A move to allow the ESM to borrow €1trn plus from the ECB would bring the intervention fund to a credible scale versus looming peripheral bond issuance.