IT´S ALL GREEK TO ME / PRUDENTBEAR.COM

It's all Greek to Me
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by Doug Noland
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September 28, 2012

  

The focus of analysis this week shifts back to Europe. My thesis remains that the unfolding European debt and economic crises provide a potential catalyst for a bout of problematic global de-risking/de-leveraging. An argument can be made that the recent rally and short squeeze throughout global risk markets actually heightens market vulnerability.


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I have expected that policy would have little success in halting the bad debt cancer spreading methodically from Europe’s periphery to its core. I have also posited that with core country Spain enveloped in Credit tumult, crisis momentum had passed a critical juncture. It is worth recalling that Spanish 10-yr yields reached 7.5% in late-July, as Italian yields surged to 6.6%.
 

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An important part of the thesis, as well, has been that the European crisis would expose Bubble fragilities fermenting in the “developing” economies, especially in China, Brazil and India. There has been important confirmation in the thesis, both from financial and economic perspectives.



Not unexpectedly, global policymakers have responded to heightened systemic risk with extraordinary vigor. In Europe and the U.S., central bankers have introduced the world to the idea of open-ended liquidity creation and market intervention. Global risk markets have responded strongly to the latest iteration in New Age monetary management, only widening the gulf between securities prices and fundamental prospects. Markets now anxiously anticipate the implementation of the Draghi Plan and Bernanke’s big monetization. At the same time, there is justified caution with respect to the impact all this liquidity is going to have on already problematic economic imbalances.



Last week’s CBB focused on the premise that “economic structure matters – and it matters tremendously.” This is one of those “master of the obvious” comments, yet these days one sees essentially no attention paid to such analysis. The evolving European crisis has provided important confirmation of this analysis. We’ve watched how Greece’s tiny little economy evolved into a formidable financial black hole. Why? Well, years of Credit excess fomented deep structural maladjustment – maladjustment that remained largely concealed so long as ample Credit/spending power was forthcoming. Post-Bubble, the Greek economy is just not capable of creating sufficient real economic wealth to support its population – not to mention its debt load. Greece’s economy remains in a steep downward spiral – and in desperate need for bailout #3 and ongoing outside assistance. Meanwhile, the social fabric badly frays or worse.



A critical question today – for Europe, for international markets and for the global economy - is whether Spain is following in Greece’s footsteps. According to IMF (2011) data, Greece ranks just below Venezuela as the world’s 35th largest economy (GDP of $303bn). About five times the size of Greece, the Spanish economy ranks #12 in the world at $1.494 TN. While not as debt-ridden as Greece, Spanish federal and regional government debt now exceeds 100% of GDP – and is rising rapidly.



Spain will require enormous financial support. It has both a substantial economy and substantial banking system – both today in serious trouble. Similar to Greece, a prolonged Credit boom has resulted in a terribly maladjusted economic structure.


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Literally hundreds of billions of euros will be required – and I fully expect the bailout tab will, in Greek fashion, expand on an annual basis. Fear for Spain and Italy was the impetus behind the creation of large bailout facilities (ESM joining the EFSF) and, more recently, commitments for open-ended bond purchases from the Draghi ECB – Outright Monetary Transactions (OMT). In a sign of the times, global markets to this point have viewed Spain largely in a positive light, as a likely catalyst for hundreds of billions of governmental and central bank market interventions/liquidity operations.


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Developments this week provided a hint that complacency might be unjustified. With an unemployment rate of almost 25%, social tensions have reached the boiling point. Public protests that had been peaceful turned violent this week – recalling a critical crisis inflection point in Athens. At least Greece has not had to deal with regional governments calling for independence.


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This week, Artur Mas, President of Catalonia, called early elections for November 25. Catalonia is the wealthiest of Spain’s 17 regions, accounting for about one-fifth of Spanish GDP. From the Financial Times: “Catalonia has a proud tradition of self-rule dating from the Middle Ages. In recent times a decisive moment came in 2010 when Spain’s constitutional court largely rejected a new statute of autonomy for Catalonia approved by the national parliament in 2006. The statute was favoured by Spain’s former Socialist government but opposed by the centre-right Partido Popular, which now holds power in Madrid.”


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There’s no love lost between Mr. Mas and President Rajoy. In recent meetings, Rajoy rejected Mas’ request for more financial independence (including control of local tax receipts) from Madrid. Catalonia’s economy has faltered badly, and the heavily indebted region was forced to seek bailout assistance from the federal government. The Rajoy government has been seen as using the crisis backdrop to wrest control from the regions, something that has inflamed latent animosities – especially in independent-minded Catalonia. Catalonians resent paying significantly more to Madrid than they received in services, essentially subsidizing other regions. They blame Madrid for their problems. Catalonian officials have been determined to take control of their own purse strings, a right enjoyed by the nationalistic Basques region. On September 11, an estimated 1.5 million protested in support of “Catalonia, a new European state” in the streets of Barcelona.


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There has been some concern that Spain’s military may be forced to respond to Catalonia’s move to independence. This further complicates an already complex economic, social, political and historical backdrop. Spain on Friday afternoon announced the results of an “independent audit” of the country’s 14 largest banks.


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As expected, the government reported a $76bn (euro 62bn) short-fall in bank capital. While the EU would like to believe these stress tests are a “major step” in restoring confidence, few analysts believe the results accurately reflect the size of the rapidly expanding hole in Spain’s banking system. It takes a major leap of faith to believe that half of the banks tested are today adequately capitalized. And from the UK Telegraph: “The audit was based on an assumption that the economy would shrink 0.3% in 2012, but this already looks outdated as conditions quickly deteriorate.”


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And while we’re on the subject of economic deterioration and incredulous assumptions, Spain Thursday released its 2013 budget. The Rajoy government plans to use spending cuts, tax increases and $3.9bn of pension reserves to reduce its budget deficit to the agreed upon 4.5% for 2013 (in the face of an expected 30% increase in debt service costs). This budget assumes economic contraction of 0.5% next year, when some forecasts now call for deepening recession and GDP contraction of at least 3%. Tuesday, Spain reported that its deficit for the first eight months of 2012 had already increased to 4.77% of GDP (vs. year ago 3.81%), with spending rising 8.9% and receipts declining 4.6%. It’s all Greek to me.


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And while Spain’s budget and “stress test” results have limited credibility, it hasn’t much mattered. Some go so far as to recommend holding Spanish debt on the view that it’s good to own what governments are about to buy (holds true, as well, for U.S. Treasuries and MBS). It’s now a matter of ironing out the timing and details of an ESM bailout and, presumably, ECB purchases in the secondary market. And, to this point, it is a case where the more rapidly things deteriorate the more confident market operators become in the imminent arrival of the liquidity onslaught.


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Here’s where things get more interesting. The original plan calling for Spain to tap the ESM for funds to recapitalize its banks has hit road blocks. Earlier in the week, ministers from Germany, the Netherlands and Finland (the Northern AAAs) argued against direct bank recapitalization, while also stating their view that problem bank assets must remain the responsibility of the sovereign.


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Besides, there is supposed to be a European-wide bank regulator in place before recapitalization fundings are considered. The whole scope of a single bank supervisor has become a source of heated debate, with Germany strongly opposed to the idea of the ECB attempting to supervise all 6,000 European banks.



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And it is worth noting that the Bundesbank’s Jens Weidmann was out in force again this week, in one instance speaking in support of the Northern AAAs: “In order to keep liability and control in balance, only risks that have arisen after common supervision is established can be taken under joint liability.


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The legacy burdens on bank balance sheets have to be underwritten by the countries under whose supervision they have arisen. Mutualization of risks can’t be the primary purpose of a banking union.” Spain has made a disastrous mess of their banking system – and market hopes that they were about to offload some of this risk to the EU/ESM is at this point little more than wishful thinking.


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Europe remains an unfolding disaster, although the region’s bonds and stocks remain speculating vehicles of choice under the assumptions that Draghi is about to lend hundreds of billions of support and, at the end of the day, the Germans will backstop the European debt markets. As for the Draghi Plan, I’ll presume many on the governing council hope that the ECB is never called upon to use its bazooka.


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Indeed, the true capacity of the Draghi Plan is much in doubt. The Bundesbank is adamantly opposed to the OMT, while questions remain as to its legality. And in Germany, it appears there is mounting political opposition to the ECB and other transfer mechanisms.


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I know, when faltering markets place the barrel of a gun to Ms. Merkel and others’ heads, mouths open and market-friendly utterances pop out. Yet, once again, we’re witnessing how it is incredibly difficult to go from talk to actual bailout program implementation. Meanwhile, the politics seem to only get more difficult by the week – if that’s even possible. Right now, markets are focused on the inevitability of a Spain bailout and the unleashing of the vaunted ESM and OMT programs. I’m not sure whether it will be weeks or months, but I do expect we’re heading in a direction where the markets will turn attention to sinking Italian and French economies and worry that these bailout programs are not going to be up to the task.