S&P is right about Europe

As I am sure you are aware by now Standard and Poor’s rating services added some downside risk to Europe over the weekend:

Standard & Poor’s Ratings Services today completed its review of its ratings on 16 eurozone sovereigns,  resulting in downgrades for nine eurozone sovereigns and affirmations of the ratings on seven others.

We have lowered the long-term ratings on Cyprus, Italy, Portugal, and Spain by two notches; lowered the long-term ratings on Austria, France, Malta, the Slovak Republic, and Slovenia, by one notch; and affirmed the long-term ratings on Belgium, Estonia, Finland, Germany, Ireland, Luxembourg, and the Netherlands. All ratings on the 16 sovereigns have been removed from CreditWatch where they were placed with negative implications on Dec. 5, 2011

The outlooks on our long-term ratings on all but two of the 16 eurozone sovereigns are negative; the outlooks on the long-term ratings on Germany and Slovakia are stable.

The outcome of these downgrades are as follows:

Country Old Rating New Rating Cut
Austria AAA AA+ One notch, loses top rating
Belgium AA AA None
Cyprus BBB BB+ Two notches to junk
Estonia AA- AA- None
Finland AAA AAA None
France AAA AA+ One notch, loses top rating
Germany AAA AAA None
Ireland BBB+ BBB+ None
Italy A BBB+ Two notches
Luxembourg AAA AAA None
Malta A A- One notch
Netherlands AAA AAA None
Portugal BBB- BB Two notches to junk
Slovakia A+ A One notch
Slovenia AA- A+ One notch
Spain AA- A Two notches

Given the performance of the rating agencies in the lead up to the GFC, and the corresponding fall out, it would be easy to set aside this news as yet another overzealous attempt by the industry to compensate for their poor performance during that period. I expect some market players to do just that, however in my opinion in this case that would be a mistake.

As Macrobusiness readers will know, my long running assessment of the European financial crisis is that the competiveness imbalance between the core and periphery is the major issue and, although some of the current policies being implemented are stated to be aimed at addressing this, the reality is that they are actually making the problem worse.  The latest Spanish employment figures are once again a reminder that austerity policy aimed at already deflating economies in order to make them more competitive are in fact counter-productive. What we have seen and continue to see from the periphery nations is a not growth at all, but a reduction in industrial production and a rise in employment, and therefore a renewed burden on the government sector meaning its attempts to deleverage fail while the private sector weakens further.

The latest news from Spain again highlights this outcome:

The number of people unemployed in Spain hit an “astronomical” level of 5.4 million at the end of 2011, Prime Minister Mariano Rajoy said on Saturday.

The figure is more than 400,000 higher than the level reached in the third quarter of 2011, when the unemployment rate hit a 15-year high of 21.5 percent, the highest in the industrial world.

“This year (2011) is going to close with 5.4 million people… who want to work but cannot,” Rajoy said, anticipating official unemployment data due to be published on January 27.

It would appear from the statement by S&P that they share my opinion:

Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”. As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.

S&P goes to talk about the underlying causes current crisis, which again would be well known to MacroBusiness readers:

In our opinion, the eurozone periphery has only been able to bear its underperformance on competitiveness (manifest in sizeable external deficits) because of funding by the banking systems of the more competitive northern eurozone economies. According to our assessment, the political agreement reached at the summit did not contain significant new initiatives to address the near-term funding that have engulfed the eurozone.

More fundamentally, we believe that the proposed measures do not directly address the core underlying factors that have contributed to the market stress. It is our view that the currently experienced financial stress does not in the first instance result from fiscal mismanagement. This to us is supported by the examples of Spain and Ireland, which ran an average fiscal deficit of 0.4% of GDP and a surplus of 1.6% of GDP, respectively, during the period 1999-2007 (versus a deficit of 2.3% of GDP in the case of Germany), while reducing significantly their public debt ratio during that period. The policies and rules agreed at the summit would not have indicated that the boom-time developments in those countries contained the seeds of the current market turmoil.

While we see a lack of fiscal prudence as having been a major contributing factor to high public debt levels in some countries, such as Greece, we believe that the key underlying issue for the eurozone as a whole is one of a growing divergence in competitiveness between the core and the so-called “periphery.” Exacerbated by the rapid expansion of European banks’ balance sheets, this has led to large and growing external imbalances, evident in the size of financial sector claims of net capital-exporting banking systems on net importing countries. When the financial markets deteriorated and risk aversion increased, the financing needs of both the public and financial sectors in the “periphery” had to be covered to varying degrees by official funding, including European Central Bank (ECB) liquidity as well as intergovernmental, EFSF, and IMF loans.

You can read more about this particular topic here. What is also interesting is that S&P go on to recognise that it isn’t just the current policies, but the euro itself, that is adding to the downside risks:

It is our view that the limitations on monetary flexibility imposed by membership in the eurozone are not adequately counterbalanced by other eurozone economic policies to avoid the negative impact on creditworthiness that the eurozone members are in opinion view currently facing. Financial solidarity among member states appears to us to be insufficient to prevent prolonged funding uncertainties.

Specifically, we believe that the current crisis management tools may not be adequate to restore lasting confidence in the creditworthiness of large eurozone members such as Italy and Spain. Nor do we think they are likely to instill sufficient confidence in these sovereigns’ ability to address potential financial system stresses in their jurisdiction.In such a setting, the prospects of effectively intervening in the feedback loop between sovereign and financial sector risk are in our opinion weak.

As I said in my weekend post the issues of Europe aren’t purely economic. What we have also seen over the last 2 years is economics wrapped in a political ideology. The idea that private sector players should somehow be immune to the fallout of the failings of the European monetary system even though many of those same players profited immensely from its rise.  It is well known that if you purchase an equity share or an unsecured bond then you are rewarded with an interest rate that reflects that there is a risk that you may not get repaid.  The riskier the investment the higher the compensation, it is quite simple really, yet for some reason the political-elite of Europe insist that these basic tenants of investment need not apply.

This ridiculous situation simply adds to the problems because nations that have no capacity to deleverage without deflating their real economic outputs, and therefore income, are being forced to meet their existing obligations. It is a simple fact that “bills that can’t be paid won’t be”, yet for some odd reason this message appears to be lost whenever an EU summit gathers.

The fact is that without some form of large compensatory income non-competitive nations will not be able to meet their existing obligations under a regime of supra-European austerity. What is likely to occur, as has become even more evident in the most recent European PMIs, is that the core nations will be become relatively stronger, the weak weaker, but overall the whole economy of Europe will shrink.

Those exact risks are mentioned by S&P:

The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures. Instead, it focuses on what we consider to be a one-sided approach by emphasizing fiscal austerity without a strong and consistent program to raise the growth potential of the economies in the eurozone. While some member states have implemented measures on the national level to deregulate internal labor markets, and improve the flexibility of domestic services sectors, these reforms do not appear to us to be coordinated at the supra-national level; as evidence, we would note large and widening discrepancies in activity and unemployment levels among the 17 eurozone member states.

Given that S&P has placed all but two of the Eurozone nations on negative watch and they can also identify so many downside risks you have to wonder exactly how they think this spiral down will be halted.  Their assessment of the ECB’s action appears to hold some clues:

In our view, the actions of the ECB have been instrumental in averting a collapse of market confidence. We see that the ECB has eased its eligibility criteria, allowing an ever-expanding pool of assets to be used as collateral for its funding operations, and has lowered the fixed rate on its main refinancing operation to 1%, an all-time low. Most importantly in our view, it has engaged in unprecedented repurchase operations for financial institutions.

In December 2011, it lent financial institutions almost €500 billion over three years and announced further unlimited long-term funding auctions for early 2012. This has greatly relieved the funding pressure for banks, which will have to redeem over €200 billion of bonded debt (excluding in some jurisdictions sizeable private placements) in the first quarter alone. By lowering the ECB deposit rate to 0.25%, we believe that the central bank has implicitly tried to encourage financial institutions to engage in a carry trade of borrowing up to three-year funds cheaply from the central bank and purchasing high-yielding government bonds. Recent Italian and other primary auctions suggest to us, however, that banks and other investors may still only be willing to lend longer term to governments facing market pressure if they are offered interest rates that, all other things being equal, will make fiscal consolidation harder to achieve.

Reports indicate that many investors had hoped that a breakthrough at the December summit would have enticed the ECB to step up its direct government bond purchases in the secondary market through its Security Market Program (SMP). However, these hopes were quickly deflated as it became clearer that the ECB would prefer to provide banks with unlimited funding, partly with the expectation that those liquid funds in banks’ balance sheets would find their way into primary sovereign bond auctions. This indirect way of supporting the sovereign bond market may yet be successful, but we believe that banks may remain cautious when being faced with primary sovereign offerings, as most financial institutions have aimed at shrinking their balance sheets by running down security portfolios in order to comply with higher capital requirements, which become effective in 2012. We believe that the ECB has not entirely closed the door to expanding its involvement in the sovereign bond market but remains reluctant to do so except in more dramatic circumstances. In our view, this reluctance is likely prompted by concerns about moral hazard, the ECB’s own credibility (particularly should losses mount), and potential inflation pressures in the longer term. We think it may also be the case that the ECB (as well as some eurozone governments) is concerned that governments’ reform efforts would falter prematurely if market pressure subsides.

We believe that the risk of a credit crunch remains real in a number of countries as economic conditions weaken and banks continue to consolidate their balance sheets in light of tighter capital requirements and poor market conditions in which to raise additional equity. However, the monetary policy actions described above may mitigate the risk of a more extreme tightening of credit conditions, which, if it were to come to pass, could put further pressure on economic activity and employment.

In summary, while the monetary policy reaction has not been as accommodating as many investors may have anticipated or hoped for, we believe that it has nevertheless provided significant breathing space during which progress on policy reform can be made. Furthermore, the ECB may yet engage in additional supporting steps should the sovereign and bank funding crises intensify further. Therefore, we have not changed our monetary score on eurozone sovereigns.

I somewhat disagree with S&P’s assessment of the success of the ECB’s operations. Although there is evidence that the LTRO has been successful in providing lowering sovereign yields it is not clear at all that this operation has been successful in producing the outcomes expected of a “repo” operation of this size. The basic function of a “repo” is to ensure that central banks monetary policy changes are represented in the private sector via a manipulation of the interbank system.

In his most recent press conference the ECB president, Mario Draghi, was unconvinced that the LTRO was effective in “unclogging” the transmission of monetary policy because the interbank market was still frozen and there was growing evidence of deleveraging occurring in peripheral Europe. With an interest rate at 1% and half a trillion dollars in liquidity in the banking system you would normally expect to see the European private sector in credit overdrive. The fact that this is not the case suggests that the ECB’s actions have not been as successful as expected. There is another 3-year LTRO to come on March 1, which I expect to be well used, but that positive must be balanced against the fact that any extension of the deleveraging by the private sector in the absence of counter-cyclic fiscal policy will lead to a deterioration of banking system asset quality, and therefore, begin to negate any success provide by central bank operations.

Obviously this outcome  isn’t a surprise. Even without the pressure of bank recapitalisations it is still very unlikely that a private sector under a program of government austerity isn’t going to have a renewed vigour for credit expansion. What we are likely to see in 2012 is a continuation of deleveraging across Europe and banks following by attempting to shrink their balance sheets to meet capital requirements.

Although I don’t completely agree with S&P assessment of the ECB I do agree with the following statement:

the ECB may yet engage in additional supporting steps should the sovereign and bank funding crises intensify further

There is no doubt in my mind that this will be the case for no other reason than the “fiscal compact” is just the same policies we have seen over the last 24 months. If periphery nations are forced to deflate their economies in line with their productive capacity under the current European policy settings then the ECB will have no choice if it hopes to meet its mandate of price stability. The fact is that only after the existing debts are written off can Europe enter a phase of economic recovery.

The question that I think we will see answered in 2012 is exactly how this will occur. Will it be by default, starting with Greece, by transfer via yet another newly cobbled together shared issuance mechanism, or via the continuation of the expansion of the central bank’s balance sheet? S&P appears to be siding with the later which, given recent history, I think is a fair bet.

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  1. Hubert Cumberdale

    The constant manipulation and attempts to delay the inevitable can only end badly. Everyone has heard the term “Black Swan” coined by Taleb, but I highly recommend reading the following article by Taleb and Mark Blythe “The Black Swan of Cairo”. It’s an interesting read and approaches global economic problems (and others) from a slightly different perspective ie: what happens in complex systems generally when volatility is suppressed.

  2. I’m curious (and a little frustrated) here: sure, we understand the problem (government deleveraging out-of-cycle), we understand the symptoms, but do we have a cure or a solution or a treatment of any credible kind?

    The natural thought to the question of government deleveraging causing economic shrinking would be for increased government spending, but these governments can’t get their bonds sold in the current circumstances, let alone asking for more money…

    So the alternative is printing? But they can’t print because they don’t control their own money supply…

    So the alternative is getting out of the Euro? But that saddles them with euro-denominated debt and massive capital flight, even without the political difficulties of doing so…

    so MacroBusiness, authors and commenters alike, what’s the solution? Imagine you’re in Merkozy’s boots for a day 🙂

    • There are only two possible solutions.

      1. Default either orderly or disorderly, or
      2. ECB purchase of excess debt from banks and sovereigns to allow stable GDP and at least growing employment, if not reducing unemployment.

      No electorate will wear a spiral of depression for more than a few years.

      When countries get out of the Euro they will default and they will legislate all their debt into an amount of their new local currency and to preserve local ownership of assets they will have to do it for their citizens and businesses as well.

      Otherwise they are debt slaves forever.

        • In the end banks are just companies. If they fail, let them, then wipe out the debt and just start new ones. There’s nothing particularly special about banks. It’s only years of propaganda that have convinced people that they are. As Karl Denninger put it, we need a banking system but not any particular banks.

          • The problem is that people have their money deposited in particular banks, so it’s not so simple as letting them get wiped out.

            And as for that, banks aren’t ‘just companies’ – their role in the money supply makes them quasi-government in how they behave in the market. Unfortunate truth but that’s why they were bailed so heavily in the GFC.

    • The stronger economies should provide support to the weaker economies.. they will have to… but first they want to make sure the weaker economies put their balances in order. Negotiations will go on for a while; the final solution will be a combination of:

      – EURO depreciation (finally happening)
      – A way for stronger economies to help weaker economies finance their debt at better rates (eurobonds or similar mechanism, ECB buying bonds, etc.)
      – Better fiscal integration (balanced budget in constitutions)
      – Money printing.
      – A Marshall plan for the EU periphery as soon as things stabilize.

      There will never be any default, since a lot of government debt is held by their own citizens and you can’t default only on the foreign part.
      Any default in larger economies (e.g. Spain / Italy) would see an economic depression that would eclipse the GFC, and no one has interest in that.

      One very aggressive solution could be to print 1 or more trillion euro and proportionally distribute that to every EU country.

  3. Nice one DE. It seems that S&P have finally got their act together.

    I’m not entirely convinced you have understand the multiple stupidities of the Franco-German plan for world monetary domination.

    You are clearly aware of the way it serves some segments of German society very well and disadvantages nearly everyone else. This is well illustrated by Greece – German and French suppliers of military equipment arrange the sale of their goods to Greece and arrange bank finance with French and German banks and presumably arrange suitable donations to the Swiss bank accounts of the Greek officials involved. I suspect a rather large portion of Greek debt was amassed in this way.

    The problem I think you overlook is the idea of having the most stable currency (a quasi gold standard in effect) is flawed. It means your currency is going down in value at a slower rate than every other currency. The only way to achieve this is likely to be to have a system of annual pay cuts. Sound like a good idea?

    This is the essence of Dutch disease, a high currency leads to loss of export earnings which can only be countered by regular pay cuts. What actually happens is that entire industries are bankrupted and lost to countries with lax monetary policy.

    This is very relevant to Aus and NZ as I feel our central banks do not understand this. The object of our inflation targeting should be to match our inflation rate to some sort of weighted world average inflation rate. That way internal inflation should equal external inflation.

    This approach would cause problems but would preserve long term competitiveness. Personally I think our central banks should inject liquidity by purchasing suitable tangible assets that take real human effort to create. So they should buy gold not foreign currency reserves, as the latter only take a few keyboard strokes to create via a double ledger entry. It does not have to be gold as such but it does need to be a tangible good that takes real human effort to create.

    My simplified version of this theory is that the RBNZ should buy a tonne of gold a day if the exchange rate is above 75 US cents. The idea is to create a steady pressure in a particular direction in order to preserve what passes for industry in these parts.

    The alternative has been well explored – low interest rates leading to asset price bubbles and wholesale destruction of manufacturing business.

    I’d be interested in your thoughts as an economist on this approach. I’m just a simple businessman who tries not to get destroyed by government stupidity.

  4. I expect the Euro leaders to continue to take the teenager decision model (courtesy of John Mauldin). They will always choose the easiest option until these are exhausted; then choose the least unpleasant option until these are all used up; and finally they are forced to face the real issues.

    A likely scenario is that Greece defaults, then Portugal, then Ireland, Spain and Italy revolt against their Franco-German overlords and threaten default. Then Germany leaves the Euro.

    In that way the leaders of Europe fulfill their destiny.