On Saturday evening news began to spread that the Euro zone was preparing plans for a Greek default and that this default would involve a 50% write off or haircut for her existing debts. As you can imagine the news created quite a furore particularly when it emerged that the latest trip into a world of fantasy by Europe’s leaders involved waiting until November! In the world of reality markets were likely to begin responding late Sunday evening UK time when Asia started trading.
The International Monetary Fund responds
At the same time the IMF put out a statement which proclaimed that it was ready to help but its position was summed up by this part of it.
We are encouraged by the determination of our euro-area colleagues to do what is needed to resolve the euro-area crisis. We welcome that the IMF stands ready to strongly support this effort as part of its global role.
As ever with official statements these days there is an element of unreality about this. For example Euro zone and officials have spent the last 18 months or so dithering about the crisis they find themselves in! Indeed at times their actions have made it worse and not better. So the first sentence is in fact the opposite of reality. Unfortunately for the IMF it did not even get its own situation right as later in the statement we saw this.
Review of the adequacy of Fund resources;
Rather than being ready to help the IMF is worried that it will run out of funds if there are heavy drawings on its resources. Minds immediately turned to the problem that is Italy which would certainly be a heavy draw on IMF resources that they could run out. So it is clear that should matters deteriorate the IMF itself may only be able to help in a limited way.
This is an area where I have form as I have long questioned the role that Msr Strauss-Khan gave the IMF and I discussed this matter in detail on the 8th of June 2010 here, http://www.mindfulmoney.co.uk/wp/shaun-richards/the-international-monetary-fund-wants-more-of-your-money/. Just to give you a taste of it here is a quote from that time from Youssef Boutros-Ghali.
“If we are going to start including funds made available to Europe, then the IMF is not properly resourced,” he said. “We need to increase Special Drawing Rights very significantly.
As you can see this problem was known then but putting politicians in charge of the IMF has led to the same results as elsewhere in that it has over-stretched its resources. The IMF did,however give us a route map for progress for the Euro zone.The strategy is to restore sustainable public finances while ensuring continued economic recovery.
Good luck with that by the way…..
Default for Greece will ruin the European Central Banks balance sheet
One of the features of the Euro zone response to the peripheral debt crisis has been to dress up tactics as a strategy. One example of this that will be horribly exposed by a Greek default is the Securities Markets Programme of the European Central Bank. This involves it purchasing bonds and debt from countries in trouble to try to help them recover. I discuss it problems regularly and as we stand it is currently failing to help Italy. There will be an update later but so far it has placed 152.5 billion Euros of debt nobody else wanted at that price on the ECB’s balance sheet. Accordingly dealing with it has become the responsibility of the Euro zone’s taxpayers.
Why will a Greek default expose the flaws in this?
We do not get an exact breakdown of the purchases made but the ECB is holding around 45 billion Euros of Greek debt via this programme. Furthermore in spite of the fact that prices have fallen substantially since it purchased most of this it has made the assumption that sovereign nations in the Euro zone cannot default and that it will get all its money back. You may be beginning to spot the flaw here! Even more unbelievably it does book the interest as a profit! Only losses get assumed away.
So an actual default of the size suggested would leave the ECB with around 22/23 billion Euros of losses overnight that can no longer be assumed away. Even worse for the ECB it has a capital base of 5.76 billion Euros which it is in the process of expanding t0 10.76 billion ( I wonder why….) but as is typical of Euro zone actions most of the extra funding has not yet been paid.
The 8%/92% split
The ECB will not take all the losses discussed above ( it can’t..) as it has the rule described above where it will split the losses with its shareholders the national central banks which make it up. So far they have only taken profits from this programme in the type of financial alchemy I discussed earlier. So the Bank of Greece, Central Bank of Ireland and Bank of Portugal will have to tak their share of the losses.
This burden will go to their taxpayers which would be fine if they had any money to pay it with. If they did we would not be in this position!
The Covered Bond Purchase Programme
Here back in the summer of 2009 the ECB purchased some 60 billion Euros of what it calls “high-quality collateral” which immediatly poses the theoretical question of if it is such high quality why nobody else wanted it and the ECB had to intervene in the first place! As we step into another full blown banking crisis we can see that the ECB must have real problems with the quality of the assets underlying these bonds. So there are more losses tucked away here.
Other liquidity providing operations
I have added up the various liquidity programmes of the ECB this morning and they come to 570 billion Euros. Against this the ECB will have received quite substantial amounts of Greek debt as at the time it was the highest yielding asset that was preceived as safe. Now this is a different situation as the ECB will apply discounts and the assets do not belong to it, but what will it do if some banks collapse and it is left with Greek debt that has just been cut by 50%? It will have provided 100% liquidity but only have a 50% asset.
Contagion
The problem for the ECB will be exacerbated by the fact that Ireland and Portugal will be looking on and it would only be natural for them to want to cast off the shackles of as much of their debt as they can. Indeed because of the way her problems came from her banking system I have argued before that Ireland is the country which would most benefit from a default. In essence she could cast her broken banking system aside.
So the problems for the ECB would multiply and be far more than her capital. And that is before we get to the problem that is Italy.
How might the ECB respond to this?
As the emergency escalates we cannot rule out an emergency interest-rate cut as a reponse to what is now taking place. I would imagine that the ECB is under enormous pressure right now from Europe’s politicians to do exactly this. Tjis would be at best embarrassing for an organisation which was only recently embarking on a series of interest-rate rises.
I also expect the central bank liquidity swaps programme to be used heavily and we may see more recapitalisations of European banks with French ones currently in the frame.
Claims for the European Financial Stability Facility have now gone beyond fantasy
I discussed the problems of the EFSF only on Friday. This instrument was supposed to be in operation soon after the “shock and awe” announcement of the 10th of May 2010 and yet it still lacks the promised firepower of 440 billion Euros some 16 months later. In spite of further claims of progress at the July 21st meeting of Euro zone leaders only Greece (who doesn’t have to contribute..) has actually ratified it since.
And yet we are told that it will mimic Superman and emerge from a telephone box able to deploy some 2,000 billion Euros to solve Europe’s problems. Depending on who you talk to it will be super-EFSF or a leveraged EFSF. The stupidity of a leveraged EFSF has to be seen to be believed.
Let me give you two major flaws in all this.
1. The EFSF has no money it has to borrow it. In a crisis it may not be able to, what then?
2. Countries in trouble fall off the list of contributors. For example Greece, Ireland and Portugal already have meaning that the 440 billion objective is currently only going to reach 410 billion Euros. Should Italy fall of the list then a much larger sum will be lost placing a bigger and bigger burden on Germany, France and so on. So the lifeboat is inherently unstable in a crisis!
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