From the “Doom Loop” to the Black Hole.
By Don Quijones, Spain & Mexico, editor at WOLF STREET.
“Despite uncertainty over Brexit — formally triggered last week by prime minister Theresa May — central bankers from around the world see the UK as a safer prospect for their reserve investments than the Eurozone, a new poll reveals”: The Financial Times.
At first whiff, this may smell counter intuitive. After all, it’s the UK that’s supposed to be in the weaker negotiating position over Brexit terms. It also risks losing a sizable chunk of its core industry, finance. Yet according to a survey of reserve managers at 80 central banks, who together are responsible for investments worth almost €6 trillion, the stability of the monetary union is their greatest fear for 2017.
They have good reasons to worry. Here are three of them:
1. The Doom Loop is Back in All Its Glory.
In fact, it never went away; it was just squeezed into temporary irrelevance by the ECB’s mass purchase of Eurozone sovereign bonds. The biggest beneficiaries are Italy and Spain where banks’ balance sheets are overflowing with bonds of their individual governments — all considered “risk free” for regulatory reporting.
In 2012, Spanish banks held a staggering 32% of Spain’s national debt (excluding regional and local debt). At the end of 2016, that figure had shrunk to 22.7%, or €168 billion. This scheme has kept the doom loop in some form of check, but shoveling as much peripheral sovereign debt as possible from peripheral banks onto the ECB’s books is not a sustainable long-term solution — not when the ECB’s balance has already crossed the €4-trillion mark. That’s the equivalent of 38% of the Eurozone’s GDP, well in excess of the Fed’s 23.7%.
The moment the asset purchases slow, however, the Doom Loop kicks in again, as has happened in the last few months. After the ECB announced that it was paring down its asset purchases from €80 billion a month to €60 billion a month, the purchase by Italian and Spanish banks of their respective national bonds began ticking up again.
When rates begin rising, those same banks will begin bleeding losses from their current holdings of government debt. As a new report by Spanish consultancy firm Analistas Financieros Internacionales (AFI) warns, over 70% of the fixed income assets held on the balance sheets of Spain’s biggest banks are prone to price variations, and in the worst case, the solvency of some banks could be called into question. In Italy, as many as one-quarter of the banks are already verging on insolvency. French banks have very limited exposure to French government debt but they are estimated to hold over €250 billion of Italian bonds.
2. Rising Imbalances.
The financial imbalances in the Eurozone are growing and in some cases have exceeded the crisis levels hit in 2012. The best indicator for this is Target2, standing for Trans-European Automated Real-time Gross Settlement System, which, month after month, has tracked the accelerating capital flight from the region’s periphery (Italy, Spain, Portugal, Greece and Ireland) to the core (Germany, the Netherlands, and Luxembourg).
In March, Italy’s Target2-deficit — the total amount the Bank of Italy owes other national central banks in the Eurozone (mainly Germany’s) — widened by €34 billion to a fresh record of €420 billion. At the height of the sovereign debt crisis in 2012, it was just €290 billion. In Spain things are not much better: in February its central bank owed €361 billion, €25 billion more than at the height of its banking crisis in 2012.
The ECB asserts that record T2 balances are pure accounting values and should be viewed as a benign by-product of the decentralized implementation of QE rather than renewed capital flight. Draghi refers to them even as a form of solidarity within the European system — a way for the core to help fund the periphery.
But in a recent letter to Italian EU politicians the same Draghi maintained that such debts should be settled in full should Italy decide to leave the euro. With Target II liabilities of close to 25% of GDP in Italy and above 30% of GDP in Spain, this poses a double-barreled question: how, and in what currency?
3. A Big (and Growing) Black Hole in EU Finances
If the first two problems are primarily monetary in nature and are exclusive to the Eurozone, the third is purely fiscal and affects all EU countries. At the heart of Brussels’ finances is a growing black hole. At the end of last year it reached €238 billion, up from €99 billion in 2002. This is the so-called reste à liquider, or RAL, which is a stock of commitments at the end of each year that have been made in annual EU budgets, but which are deferred for payment in later budgets.
Even under normal situation, this would be cause for concern. But the EU’s current fiscal situation is anything but normal: the bloc is in the process of losing one of its biggest net providers of funds, the UK. As the German economist Hans Werner Sinn recently put it, “Because the UK is so large, its withdrawal is economically equivalent to the withdrawal of 20 of the smallest EU countries – 20 out of 28, which we have in total.”
Other EU countries will have to pick up the slack. Günther Oettinger, the German commissioner, said as much in February. Those countries include Italy, whose public debt amounts to 133% of GDP, among the highest in the world, and it hasn’t even started bailing out its banks yet. In other words, the people in Italy may have to pay more taxes to Brussels while suffering more austerity, in the process becoming even more disenchanted with the euro project, hardly a strong foundation for a long-term future. By Don Quijones.
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