The European Debt Crisis in 2012

8 January 2012 | Philip Ammerman

The headlines in Europe will continue to be dominated by the need to address two critical issues: the refinancing of sovereign debt, and the inability of the banking system to do so in parallel with private sector obligations and their own recapitalisation needs.

Unfortunately, the relatively simple process of refinancing is exacerbated by the normal political fragmentation and duplicity, but also by electoral interests. The example of Greece, where a caretaker Prime Minister had to once again implore his cabinet for cooperation and real progress, is indicative. Yet the same paralysis is in effect in Spain, Italy, France, Belgium and even Germany.

As a result, we can a “crise du mois”, a monthly crisis, or perhaps even a crise du jour, in the Eurozone each month in 2012. In Greece, the crisis has already been planned, given the need to refinance EUR 15 bln of bonds in March, and with the Troika already indicating that the first bail-out installment plan will be delayed by 3 months. Either Greece will have to raise short-term funds via high-interest treasury bills (as it did in December to stave off default), or it will have to raid its bank stabilisation fund, to reach this amount.

The problems in Italy are far higher: Italy needs to refinance EUR 300 billion in 2012, with about half of this occurring in the first six months. Total Eurozone refinancing needs are estimated by Citigroup at EUR 1.1 billion in 2012.

So far, both France and the EFSF have been able to complete bond issues in the past week, but for very low amounts and with lower debt covers. Italy and Spain return to the markets in the week of January 9th and thereafter. The real test will occur in January and February.

In December, a long-expected scenario materialised as the European Central Bank lent nearly EUR 500 billion in 3-year, low-interest loans to European banks. Together with its limited interventions in sovereign finance, this was enough to close December without a meltdown, which is something most desperate bankers were looking for. Yet it is unlikely to persist into 2012. If it does, it will require a massive expansion of the ECB’s balance sheet, which at some point will exceed the limits of credibility.

The Eurozone system will be tested, possibly to the breaking point, in the next 3-4 months. Only non-sovereign lending by the ECB, the IMF and possibly the EFSF remain to save the situation. The breaking point will be illustrated by events:

At least two failed Eurozone national bond auction, meaning debt cover ratios below 50%
Sustained yields above 7% for Spain and Italy
A downgrade of two or more Eurozone countries, placing the EFSF’s rating in jeopardy.

These events will have inevitable consequences, chief of which will be a financial panic. To avoid this, it is likely that the seven “grand bargain” conditions I mentioned in my post of December 2nd will be put into effect, namely:

Extending ECB lending as well as maturity terms to banks. This would require quantitative easing for the private sector by the ECB, and also extending maturities from 1 year to possibly 5 years.
As part of such an agreement, banks agree to repurchase a certain share of Eurozone sovereign debt, most likely in the range of 60-65% of total outstanding debt.
The IMF steps in with a formal austerity programme for Italy and Spain, enabling them to refinance part of their needs using ECB-IMF resources. It is likely that IMF-ECB resources of at least EUR 200-250 billion will be needed.
The ECB is given limited authority to continue secondary market sovereign bond repurchases, perhaps by another EUR 100-150 billion.
The banks agree to participate in the European Financial Stability Facility (EFSF) capital increase, perhaps to EUR 800 billion. This adds about EUR 400 billion to the fund, which is then used to repurchase sovereign bonds as well as possibly bank refinancing.
The Eurozone adopts much stricter rules on the public finances of its member states. It is not impossible that a "new Eurozone" emerges.
The European Banking Association (EBA) delays its core capital increase, or alternatively allows an exemption for central bank guarantees or ECB credit lines. It is difficult to see exactly how this would work, but some solution will no doubt be found.

Conditions 1 and 4 have already been implemented in whole or in part, and will almost certainly be extended.

Again, it is worthwhile to emphasize that these “solutions” address the symptoms of the problem, not the root causes. These root causes are familiar, and include:

A paradigm shift in the economic model of the “West”, from a producer of goods and services, to a consumer of goods and services using loan finance. This has in turn been further exacerbated by the implementation of unrealistic free trade agreements which have destroyed any vestige of competitiveness in many manufacturing segments.

Excessive reliance on a few consumption-based economic sectors such as retail, catering, tourism, finance and the still over-valued real estate/property sector.

Demographic decline, exacerbated (or “leveraged”) by the implied or legal acceptance of millions of low-paid immigrants who can no longer be accommodated under prevailing economic conditions.

A burgeoning public sector, which is based on the direct provision of services and future benefits (such as pensions) and which can no longer be maintained.

It remains to be seen whether the policy recommendations we see made at the European or national levels will be sufficient to address these root causes. I do not believe they will. In general, European elected officials are using first generation policy tools to fight what amounts to third generation policy problems. It’s a bit like giving the captain of the Titanic a teaspoon to bail out his 46,326-tonne vessel after it hit the iceberg.

There are very few countries in Europe today that have unlocked a “golden mean” for managing their economic competitiveness, and unfortunately this number is declining, because of Eurozone and EU obligations, because of declining national and international economic conditions, or because their own societies are ageing.

As a result, I am extremely bearish on 2012, although it is possible a short-term compromise is reached which enables the Eurozone to keep ticking over long enough. It will be necessary for everyone, whether a company or an individual investor or wage-earner, to prepare for far worse trading conditions than 2011.

Toward a Grand Deal on Bank Refinancing and Sovereign Loans

December 2, 2011

The End of Leverage

November 25, 2011

Philip Ammerman