Will the European Central Bank in effect be bankrupt and does it matter? In other words who pays…..?

Late on Friday evening we saw the continuation of a theme which is becoming more and more familiar. This involves Euro zone government bond markets improving with prices rising and yields falling. Examples of this on Friday, involved the Italian ten-year bond yield dropping below 6% and the Spanish equivalent dropping below 5%. However this is then followed by a ratings agency downgrading the credit rating of some Euro zone nations. Previously it has been American agencies who have played this “game” but this week it was the (mostly) French owned Fitch which took centre stage by downgrading 5 countries.

Fitch on Spain and Italy

Spain

 a re-assessment by Fitch of the potential financing and monetary shocks that members of the eurozone face in light of the increasing divergence in economic, monetary and credit conditions and prospects across the region, which is also a factor in the downgrades of some other eurozone sovereign governments.

- Spain’s significant fiscal slippage in 2011 and deterioration in the macroeconomic outlook with adverse implications for the medium-term outlook for public finances.

To which it added this

The new government has also announced it will require the Spanish banks to increase their provisions by EUR50bn (EUR35bn net of tax)……………the Spanish banking sector as a whole will likely need more capital support from the state

Italy

Fitch has the same first reason here i.e a general Euro zone deterioration and then a second one which is somewhat self-fulfilling.

a permanent upward shift in Italy’s relative cost of fiscal funding and consequently an increase in the interest rate growth differential with adverse implications for long-run public debt dynamics

So there you have it Italy is in trouble because it is in trouble! This is confusing what is mostly a symptom with a cause to my mind. And of course as noted above, if high bond yields were the problem they were showing signs of improving. It would be much better I think if Fitch had made more of a case for a cause for example.

Italy’s high public debt and low potential growth rate have rendered it especially vulnerable

And that this is an issue going forwards.

the greater reliance on raising revenues (which account for around two-thirds of the planned deficit-reduction) implies that the tax burden and public spending will remain high by international standards

Added to this is the genuine doubts that Italy can carry out these reforms. For example will her unelected technocratic government be able to stay the course should the going get tough?

Comment

New data this morning has confirmed the problems ahead for both Italy and Spain. Starting with Spain we have seen her economic growth rate be confirmed at -0.3% for the last quarter of 2011 and if we look back to her recent history we see that it was Q2 of 2008 where growth was zero  and that she is looking in overall terms at a four to five-year slow down. Italian business confidence has dipped to a reading of 92.1 which is the worst for two years.

Greece and her debt haircut or private-sector involvement talks

These have taken on the job of being the most like the boy who cried wolf they can be as promised deadline after promised deadline comes and goes with only a new set of promises to replace them. The latest promise expired last night.

However even if the current deal comes to fruition there is a fundamental problem which is that its impact on Greece’s national debt is too small to be of significant influence. In something which is both an irony and an example of a complete lack of long-term planning this is partly caused by the holdings of the European Central Bank which holds approximately 45 billion Euros of Greek government bonds. In addition to this you need to refinance the Greek banks who have large holdings or they would collapse and lending from the International Monetary Fund is always given on the basis that it is “senior” i.e no haircuts for it. This is before we get to the impact on Greek pension funds.

More and more talk has centred on the possibility of the European Central Bank taking a haircut on its holdings too. The ECB’s reponse remains along the lines of Dawn Penn’s ditty.

No,no,no

Oh perhaps we should say nein,nein,nein! But it looks as though pressure is building on this front and may be gaining some traction. The standard of official thought being what it is some ideas are at best half-baked as suggestions that the European Financial Stability Facility could take the bonds and the losses ignore the impact on it! The EFSF which is my “unstable lifeboat” has troubles enough of its own. Giving it losses on a large scale might make it founder completely.

A problem for the ECB is that it lacks capital

The fact that the ECB lacks the capital to deal with the tasks facing it has been a regular theme of mine and I have returned to the subject from time to time to point out that if it were a private bank it would be insolvent. The official denials and bombast in response were inevitable but were followed by a plan to increase the ECB’s capital ( why if it is unnecessary …..?) and it has now risen to 6.36 billion Euros if we count members of the Euro.

Oops

There are various ways of calculating the losses from the Greek PSI plan but if we stick to the headline 50% number we see this. If you have 45 billion Euros of holdings then you lose 22.5 billion Euros which is inconvenient,to say the least, if your capital is less than a third of that!

If you use net present value calculations then it looks as if the losses over time (some losses are for now and some for the future) will head into the mid-60s in terms of percentages, and so as time goes by there will be extra losses. Even worse for the ECB.

There is a presentational problem here to say the least and we hit on one of the fundamental flaws of the construction of the ECB. It has backing from the various national central banks and the respective treasuries but the situation is not clear-cut. By contrast the UK taxpayer clearly backs the Bank of England and the US taxpayer backs the Federal Reserve.

What happens: The 8%/92% rule

An example of how this was never properly thought through comes from the fact that the rule given above was established in effect by a letter in November 2010 by the then head of the ECB Jean Claude Trichet. In my opinion he clearly exceeded his authority but as he was dealing with a group of people who as the group Sweet’s song Blockbuster  pointed out in a rather prescient lyric.

Does anyone know the way? Did we hear someone say
We just haven’t got a clue what to do
Does anyone know the way? There’s got to be a way

It seems to have survived unchallenged. So now we have an estimated 22.5 billion Euros of losses initially which would be split 1.8 billion Euros to the ECB and 20.7 billion Euros passed down to the 17 national central banks (and eventually their taxpayers).

With one bound they are free?

Not quite as this ruse may get the ECB out of jail free so to speak but if we look at the impact we see quite a few troubled countries receiving losses. For example the Bank of Greece would get 2.8% of the losses,  and the Bank of Portugal would get 2.5% of them. Two countries which plainly do not have any money get losses and in some ways even worse those on the edge get them too, so they are made weaker. The Bank of Spain would receive losses of over 2 billion Euros and the Bank of Italy would receive over 3 billion Euros. That is before the wailing and gnashing of teeth that would come out of the German Bundes bank as it imagines trying to defend how it allowed around 5 billion Euros of losses  to become its responsibility at the German Constitutional Court.

A “nice little earner” for the ECB

Whilst capital losses are a problem for the ECB it does have money coming in on a substantial scale. As its money market programmes are now so large at round 850 billion Euros even an interest-rate of 1% gives it 8.5 billion euros a year. It pays a lower rate on deposits with it and of course amounts vary but even allowing for the deposit payouts it looks likely to earn more than 6 billion Euros a year (h/t Lorcan RK for drawing my attention to this).

Before the hard-pressed Euro zone taxpayer lets out too much of a cheer at this please remember there is a catch. All of the dodgy collateral that it has taken on board leaves us with plenty of potential for a familiar theme, interest profits accompanied by (usually larger) capital losses. But,of course, the kicking the can strategy involves kicking the losses onto someone else’s watch…..

Greece’s finances

There has been a debate over whether Greece now has a primary budget surplus. Those willing to project forwards on the basis of provisional, incomplete numbers from the Ministry of Finance which have not coincided in the past with numbers from other bodies are “sure” she has one.

For myself I was struck (looking at the confirmed figures which only go up to the third quarter of 2011) by an example of complete and utter failure. The bailout of Greece was badged as reducing her debt costs and instead they have surged.

 

 

 

This entry was posted in Banks, Euro zone Crisis, General Economics, Greek Financial Crisis, Quantitative Easing and Extraordinary Monetary Measures. Bookmark the permalink.
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  • Drf

    ” The bailout of Greece was badged as reducing her debt costs and instead they have surged.”  Hi Shaun; surely it is so in all cases, since this is the current game.  The banks win – everyone else loses.  A zero sum game if there ever were any better example?

  • Anonymous

    Shaun,
    You ask, “does it matter”? My guess would be: not unless and until there is a real prospect of  the euro being dismantled entirely and/or Germany leaving the eurozone. Just a guess. 

  • Rods

    Hi Shaun

    Another excellent blog.

    If or maybe even when, the voluntary haircut on Greek sovereign debt happens, if their budget deficit is not zero or positive all they will have achieved is slowing down the rate of digging in the hole that their in.
    The only way then to stop digging will be through further defaults or growth and I think there is not going to be much growth around in Europe anytime soon.

    So, unless they have a budget surplice, all this will be is a can kicking exercise, which I guess is the most important consideration for Merkosy where they both face elections this year. I can’t see Germany accepting any ECB losses until after November as this would badly damage Merkel’s reelection chances.

    Germany’s attempted diktat to impose an EU administrator on Greece for direct fiscal rule, with  the Greek Government passing laws to make their control above and beyond the Greek Government, made me think, Germany’s up to its old tricks again. As this sort of demand is very similar to those of that megalomanic madman Hitler from 1933 to 1938 as similar tactics were used, by him to “peacefully acquire” Austria and the Czechoslovakian Sudetenland and then with the confidence that the allies would do nothing to stop him, the invasion of Poland and the rest of course is history.

    An appropriate song for this I think is The Who’s; Wont Get Fooled Again.

  • JW

    Hi Shaun
    Some estimate that the next LTRO may need to be several trillion to backstop the banks/insurance companies after whatever happens in Greece happens.
    Portugal 10 year bond yields have just gone north of the Greek position of 4 months ago.
    BDI has dropped further after the end of the CNY ( 65%) and Shanghai new property prices have fallen over 40%.
    US underlying Q4 GDP figures, 0.5%; China GDP ‘reported GDP’ not reflecting flat or declining commodity imports/energy use which tend to support BDI trends.
    3 US Carrier Groups now in the Gulf.
    Fed Q3 in March, UK Q3 next month.
    But hey, it could be worse, at least bonuses are being refused, or should it be swopped for better LTIPs and promises of CBEs?

  • The_forbin_project

    the question is  – how much debt repayments can the Greek economy sustain   afford?  

    if the “hair cut”  or default lite  does not reduce the repayments to that level then nothing has been solved.

    There’s no growth as such to be had in any economy  and its life blood is dwindling  away

    just think of what  Europe is doing over the Iranian  oil  – where’s the replacement coming from?  ( hint :  Economists tend to forget they are in a real world where the 3 laws of thermodynamics work…..)

    Forbin

  • Ian_jones

    Spain, Italy & Greece need trillions to fix them. There is no way on earth Germany will transfer the funds or allow it to be printed. I am surprised that the recent ECB intervention wasnt blocked, I guess the German public dont understand it is printed money.

  • JW

    Hi Shaun
    The attached shows the growth in the balance sheets of the largest central banks. Incidentally it also shows the exposure of US banks to the PIIGs.
    http://www.ftense.com/2012/01/us-bank-exposure-to-toxic-european-debt.html

  • Anonymous

    Hi Shaun
    I have just read that the ECB’s reserves total some 60bn euro. Would this cushion losses before national central banks start to endure them.Ofcourse a Greek haircut starts to challenge the accounting practice of the ECB, being to mark to maturity. A Greek haircut could blow this fig-leaf away.

  • Fletch

    Argumentum ad Hitlerum.  I am sure they are attempting to stop the inevitable Greek default out of love.
    EU and Eurozone countries had freely already signed up to rules about spending. So it is hardly dictating rules. The fact Germany and France themselves broke a few rules around spending is another matter.

  • Fletch

    UK government backs the BoE but BoE backs the government by printing money.  Same for the US.

    So Euro governments had been writing IOUs, which have been bought up by the ECB using their own IOUs(not referring to fiat currency quite yet).  Now they can simply pay IOUs in more IOUs and the paper IOUs which is printing money.
    Essentially I thought printing money was the end game for central banks to get out of trouble.  However unwise it may be especially in a currency union.

  • Anonymous

    Argumentum ad Hitlerum it is, but they started it with their thoughts about a ‘Gauleiter’ for Greece (and then for Portugal and then for Spain etc. etc.). Do they really think that the Greeks will see the Gauleiter and they will suddenly be able to pay the debt. The opposite is more probable. These people should read a bit of history. If this is an attempt to make Greece abandon EZ is equally deplorable. They should say this clearly and EZ should make a mechanism of disengagement from the Euro (currently is not possible) without leaving EU.

  • Andy Zarse

    Hi Shaun, you mention Greek pension funds, whose annuitants rely on the interest payments from bonds, as do the other Eurozone pension funds.

    If there is a sovereign default I underdstand most countries have a similar arrangement to the UK’s Financial Services Compensation Scheme, which means someone has to cough up for the losses and keep paying the pensioners their income on a monthly basis… imagine bailing out Italian annuities if Generalli bit the dust! Not only is this an elephant in the room, I would go so far as to suggest it is a wooly mammoth in the colloseum!

    Also, look at the final salary pension obligations – all protected under EU employ,ment law - of the Greek state assets which the Troika wants privatised ASAP… what private sector buyer is going to be happy about covering that lot??

  • Space Man

    I think that I recall the German parliament voting to back it despite widespread  public opposition, and the parliament considered it to be very much the last time it would happen?

  • Space Man


    just think of what  Europe is doing over the Iranian  oil  – where’s the replacement coming from? ”

    Saudi Arabia has said they will increase production to match any reduction in Iran.

  • JW

    Hi Vassilis
    True story. An employed female civil servant in Greece has just won a court case to get a 75% haircut on her personal debts from her bank. Apparently there is a 2010 Law that she appealed to that protects citizens under stress.If every Greek debtor now follows this route the Greek banks and ultimately the ECB will find its ‘assets’ somewhat diminished.
    The start of serious fightback by the populous?

  • Space Man

    I know where you are coming from Rods and I think that many people are thinking the same, but I don’t think it’s some grand conspiracy to rule Europe – it’s just the way things have worked out. 

    Germany is doing very well out of the current situation, and it appears to be unwilling to do very much to help, but what would we do in the same situation?

    The recent news that I found more worrying than the Greek suggestion, is that Merkel will be helping out Sarkozy with his Presidential campaign. Surely she should stay neutral and not get involved?

  • http://kkalev4economy.wordpress.com/ Kostas Kalevras

    Hi Shaun. A few comments on ECB.

    First of all, as SNB clearly put it, a central bank does not need capital, it’s the only entity that can keep operating while having a negative equity position (since it’s the only entity with a monopoly on its own liabilities and it has a structural profit position).http://www.snb.ch/en/mmr/speeches/id/ref_20110928_tjn/source/ref_20110928_tjn.en.pdf

    ECB did not buy Greek bonds at par, so the right thing to do would be to mark them at buy price on its balance sheet. Furthermore, Greek bonds pay interest over 4,5% while the ECB has a cost equal to the weekly term deposits for the SMB liquidity, which pays approximately 0,3%.

    There is a big legal issue for ECB participating as the rest of the private sector in PSI (which would probably mean that the Greek government has inserted and activated the collective action clauses). If ECB were to face any losses on its Greek bond holdings, that could be considered as indirect monetization of Greece’s debt. Oops.

    Personally, i ‘d like the ECB to mark the bonds at buy price and also rebate any interest payments over its main rate, just like the Fed rebates its profits to the US Treasury. I really cannot imagine how the ECB can be allowed to make a 10 – 15 billion profit from its Greek bond holdings while also maintaining a defacto senior creditor position. The latter would threaten any further SMP interventions, since that would mean that private bond holders would become subordinated creditors and face probable future losses. Furthermore, having 45 billion Euros of bonds maturing before 2020 makes a huge difference on the Greek debt problem. The 130 billion EFSF package is just not enough to cover interest payments, bailout loan repayments (they mature at 7.5 years) AND ECB repayments. If ECB does not participate, that would mean that the private sector will face higher haircuts sooner or later.

    One note on PSI. I don’t see anyone talking about what price the new 30Y bonds will be trading at. If the new bonds carry a coupon of 3,5% and trade with a yield-to-maturity equal to the Italian 30Y bonds (which I think can be considered the lower bound), they would trade close to 60! I find it strange that all Greek bonds are currently trading close to 21, especially since 15 would be handed out on day one as cash and another 35 as new bonds. The numbers just don’t add up and private holders will face another market-induced haircut (which will be reflected on their repo transactions using the new bonds).

  • Anonymous

    Hi Rods

    I do indeed have that song on my mp3 player and in these expect the unexpected times we look out for a pinball wizard too but they are in short supply…

  • Anonymous

    Hi Space Man

    I agree that a foreign power influencing an election has many flaws but if history and human nature are any guide then it is probably more likely to strengthen the case of the opposition!

  • Anonymous

    Hi JW

    Hasnt your favourite currency strategist shown signs of getting it wrong again?

    It is interesting I agree to see the forecast size of the February 3 year ECB LTRO rising as it begs the question of who thought it would be small? There is so much “idle chatter” about that is positively misleading and if I had the time I would keep a record for naming and shaming.

    The way this happened last summer where so many “experts” predicted the UK would be able to sell of Lloyds and RBS was another example of this issue.

  • Anonymous

    Hi Shire

    That is a real minefield you have stepped into and good timing as I have just watched a programme on the Royal Marines in Afghanistan!

    Once you get beyond the ECB’s own capital there are large sums of money available in theory as for example it has all the seigniorage from the issuance of Euros. But in my opinion the intention was that this and other Eurosystem money was intended to be given back to the National Central Banks as profits.

    So however we argue it and whatever ruses are used we end up with the same problem. After all if you were going to use Eurosystem money to help Greece and others it would have done a lot more good to have given it to her.

  • Anonymous

    Hi Kostas

    Let us find something where we are in agreement and of the PSI deal I can only say hear,hear to this bit.

    “The numbers just don’t add up and private holders will face another market-induced haircut (which will be reflected on their repo transactions using the new bonds).”

  • Anonymous

    Hi Andy

    You must have read my mind as that issue had been troubling me today! A friend and ex-colleague who works in the pension world had asked my advice on the rules in the UK and when I started covering the bases it made me think of how many bases there are to be covered in an “expect the unexpected” world.

    And how few the FSA in the UK covers properly in my opinion.

    I am not any sort of expert on final salary pensions in Greece but the annuity issue has troubled me as I hinted at in today’s article and it has received very little attention in the media,which is why they often get the issues wrong.

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  • Anonymous

    Yes I agree the Gauleiter idea is unworkable, the Greek civil service is likely to offer passive resistance to render the Gauleiter ineffective. Germany bears a heavy weight from history which makes it hard to walk away from the Franco-German engine of integration. I think Germany would be better to abandon the Euro and return to it’s beloved hard DMark. Yes a DMark would appreciate, but the Germans could cope – the fairy story that a DMark would destroy German economy is unprovable – it is a bogeyman story from the EU “leave us and face economic ruin” ( The EU tells the UK a similar bogeyman story )

    Europe is over endebted. Without Germany, the ECB would be free to print away the club med debts (including France).

    As the euro devalues against the DMark, Germany benefits from having it’s national debt denominated in Euro.

  • The_forbin_project

    they said that last time and did not actually do that !

    check out the oildrum web site

  • Anonymous

    Hi Shaun
    Thanks. The website says the general reserve may take the hit on ECB losses which can then be offset against annual income and shared to NCBs.

  • iya

    The ECB is “independent”, so how could the intervention be blocked?

  • JW

    Well Shaun, on the basis that getting forecasts 100% wrong is just as good as 100% correct , I am looking for a forecast of positive EUR/USD movement. With a EUR1 trillion increase in the ECB balance sheet coming , we should see EUR/USD down to 1.1 or so.

  • Rods

    And just image the sort of Greek constitutional crisis you would have, if in this sort of scenario, if you had an EU financial commissioner saying, sorry, but you can’t have this ruling as it is against our EU bailout terms!

    To me this just highlights the dangers, of appointing EU financial commissioners, where EU pressure would take presidence over national considerations. The EU would not care about the democratic implications as they have shown on numerous occasions, that democracy is just a nuisance that should not be allowed to get in the way of “The Project”.

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