Europe; Coming Unglued

The financial media have, as usual, been watching a different movie.

The financial media have, as usual, been watching a different movie.

A friend recently said in reply to a comment, 'I think we're going to hell in a basket.' She is probably right but not for the reasons she thinks. My friend was referring to the consequences of Brexit. I am referring to the structural issues which are baked into the Eurozone and which are coming unwound at a pace which is very likely to accelerate throughout 2017. Standing close to an exploding bomb is never a good idea. The further away we are the better although it will take more than the English Channel and the political aspiration, if not commitment to leave, to save us from at least some of the backblast.

Political risk in Europe appears to be growing. The truth is, it never went away. It was simply subdued temporarily by successive ECB bailouts which have rescued (some) ailing banks but have done nothing to correct the systemic flaws in the Euro which have ruined southern European economies. Now, as political risk takes front and centre stage with Le Pen soaring in the polls the underlying economic risks which have been fermenting for years are at risk of ripping loose. The means of transmission are again, most likely to be the banks. You see, nothing has really changed.

We saw during the last period of Euro stress in 2011-12 that a sell off in bonds hit the balance sheets of European banks who tend to hold their own governments debt which increased their need for bailouts. In turn, that hits depositor and investor confidence which damage the banks even more creating a death spiral requiring direct central government intervention. As you may have guessed, the three countries with the banking sector most exposed to their own governments debt are Italy, Spain and Portugal.

With the ECB scaling back its bond purchases and the rising incidence of inflation yields have been rising. More importantly, spreads have been widening reflecting growing risk between member states.

Markets have so far placed a low delta on a Le Pen victory in France. Markets are being naïve. The French electoral system is designed to keep the door firmly shut against extremist parties but with the other candidates carrying baggage of their own her defeat is far from certain. Italy’s election meanwhile could result in a government under the influence of the Five Star Movement of the Northern League, both of which are committed to leaving the EU. Markets would not wait for an EU referendum result in these countries. Merely scheduling one will result in financial chaos. Meanwhile another Greek crisis similar to 2015 looks baked in when they run out of money in July.

Investors are hardened to serial crisis in these countries but are broadly complacent in their thinking that after a lot of fuss there will be another bailout and normal business will resume. Italy’s banks still hold 276bn in bad loans and the countries debt to GDP ratio stands at 134%. With 12% of the country’s bank assets being held in national debt there is a financial death spiral just waiting to be triggered. A small issue here is that Italy is the third biggest economy in the Euro block. That won’t be an easy fix.

Portugal meanwhile is back where it started with debt as high as it was in 2010. The 78bn Euro bailout there did not reverse economic trends. It did though, save the banks, for now.

The ever sensible and cautious Germans have been trying for years to neutralise this threat, first with a proposal to limit the amount of domestic sovereign debt that a bank could own. Germany failed. The second German proposal was adopted. That was to require that bank bond holders take a draw down, to zero if necessary, before government money could be used to bail out. Unfortunately, when Banca Monti Dei Paschi ran onto the rocks in December the rules were bent out of shape by using out of date stress tests and reimbursing debtholders saying they had been misled. That prevented a political fuss in Italy but has left the potential financial death spiral in place.

Other ideas, mostly based on the ‘bad bank,’ approach have circulated in recent years and include creating two classes of bonds, pooled together from the Eurozone countries, and divided into ‘safe,’ and lets call it ‘less safe.’ Loosely, that would be Germany plus one or two other countries and the rest. Unfortunately, the Germans are not big fans of either of these plans or any of their derivatives. The Germans in fact have been playing a quite crafty and streetwise game and who could blame them. German banks have pulled back their lending to non-German companies in the Eurozone over the past few years. Their appetite for shared risk is diminishing and the banks preference for keeping their money inside their national borders reflects this.

Germany itself has its own handcart of problems. Germany will of course work hard to keep the Eurozone together but it is not without its critics from both within and from outside. Germany is under constant criticism for having the largest trade surplus in the world, something that has not gone unnoticed by the Trump administration. It is ironic that Germany is the most powerful member of the very institutions that were imposed upon it in post war Europe. Indeed, the Euro was created years later in part to tie a reunified Germany to France and losing the Mark was the price paid for reunification. The trade off for Southern Europe in being unable to devalue was access to Northern European borrowing rates which allowed much needed structural reforms to be put firmly on the back burner.

Monetary union with fiscal union blocked potential wealth distributing mechanisms and acceptance of risk sharing required Southern Europe to gift their fiscal policies to Brussels. The Eurozone crisis and subsequent austerity measures have created fertile ground for growing resentment which has fanned the flames of populist movements which are gaining traction across the Eurozone. The refugee crisis and local political scandals have poured kerosene on an already politically volatile state. Growing recent civil unrest in France, (not much reported in the UK), and less violent demonstrations in Germany, reflect the heightened political volatility.

Political and economic structural tensions in Europe will continue to rise across the Continent in the coming months. They may well be contained and then abate. Protectionist rhetoric from Washington however complicates matters somewhat and are anathema to Germany’s export led economy. How the global economy, which has been designed and built around the free movement of people, goods and services reacts to fundamental changes driven by Washington remains an open question. Certainly, a much stronger dollar would be deflationary and wipe out the glimpses of inflation we are now seeing and that has a world of implications starting with Emerging markets and the $9tr of foreign dollar denominated loans which are ticking away.

With, for the moment, inflation at the gates and with bond yields rising in France and the periphery, the increased cost of debt repayments will do nothing to stabilise matters. Equities meanwhile have been skipping along without a care in the world. They may be about to stumble. For what it is worth, I firmly believe that the whole rotten construct is closer than most believe to coming completely unglued. Let’s hope that the financial boffins at the Bank of England are earning their money and are stress testing the banking and clearing system to destruction. It won’t be so very long before risk managers across the City are once again obsessed with counter party risk.

As a quiet postscript, those investment banks such as HSBC and Morgan Stanley who are making noises about moving some staff to Frankfurt and Paris, good luck. You are going to very much need it.

What Mr Cameron Should Say

We're all pretty uninspired with being constantly berated with warnings of gloom and despondency should we have the temerity to vote to leave the EU. It goes against the national character to just give up and meekly toe the line. David Cameron and the Remain camp have so far failed to articulate a positive path forward which will not only be good for the UK but also kick start the process of drawing the rest of the EU together which is anyway, decaying from within, something that few are keen to draw any attention to. 

How then, should David Cameron tackle this deficit in vision and positive thinking?

It is a basic truism in politics that what you see on the surface does not in any way reflect what lies beneath. When all the rhetoric is over and the votes counted, many in the remain camp will be keen to restore business as usual. That would be the world where we tolerate the meddlesome excesses of Brussels and where the government of the day can park troublesome ministers or ex ministers who have been turfed out by the electorate into enhanced pension positions in Brussels. David Cameron should rip up the status quo and make it clear that this referendum is a game changer. If we vote to stay, we'll be fielding our A team from here on in, not the wheezy boys with coughs and notes from their Mum on the bench.

 A civil service office in Madras, India during the British Raj

In another age 1,000 British civil servants ran the Indian Civil Service. That was on average of one civil servant for every 300,000 Indians, (although the total number had fallen to 688 by the time of partition). It is broadly acknowledged that they did a pretty good job. All of them however, were the very best candidates for the job on offer, having studied either at Oxbridge, the School of Oriental studies or Trinity College, Dublin. Similarly, British officers in the Indian Army had to pass out in the top half of their course at Sandhurst to have a chance of being selected for the Indian Army and when serving in India promotion was subject to passing examinations in Urdu.

1975 was a more positive campaign by 10 miles of good road

David Cameron should take inspiration from this experience and  make it clear that mediocrity will no longer be accepted, that we are going to engage with Europe by deploying our brightest and best minds at the political and administrative level and no individual can expect advancement to the highest reaches of their government career paths without serious time spent in Europe. He should emphasise that his administrations new mission to 'inform and influence,' policy and decision making in Brussels has the highest priority and the British government will henceforth take a long term view of its involvement at every level. The education system, honours system, diplomatic corp and government HR policies will be directed to reflect this new positive stance. "If we are going to do it, we are going to do it better than before and better than anyone else." Europeans will immediately adopt the look of stunned mullets, such will be the hanging air of disbelief but it would sway many voters currently sitting on the fence.

The Prime Minister won't do any of this of course. He is following the advice of his advisors to, 'scare the bejeesus out of them.' Personally, I think that tactic is past it's point of what usefulness it may have had and is now producing negative drag on the Remain campaign. I happen to hold that very positive mental attitude on the prospect of leaving but can see it can swing both ways for here is the thing, optimism and enthusiasm are infectious.

Luvvie Who?

Next up in joining the unseemly rush to join the list marked, "Next Honours List," we have 300  narcissistic and self obsessed luvvies, (I've never heard of 290 of them), signing a letter preaching what is good for the rest of us. Sorry to disappoint all these precious princesses but who exactly cares what they think?

Brexit Ahoy!

As June 23rd rumbles into view the debate, such as it is, is reaching new levels of hysteria with the Prime Minister this morning citing the increased risk of a ground war in Europe as a reason not to leave the EU. That follows utter nonsense promulgated by ex heads of intelligence over the weekend in a letter to the Sunday Times, one of which has already been discredited with the disclosure that he said completely the opposite in a recent private conversation. The spooks, whose entire careers are based on disinformation and manipulation, should get back in their Box. 

The problem for the Remain campaign is that the British voter has so far been implacably unmoved by scare tactics and misinformation from both sides. It is a bigger problem for Remain because they need to mobilise their voters on the day whereas the Brexit camp are already motivated to make an active choice. Remain will also suffer because many students, who generally are more relaxed about the status quo, will have left university, some will have cocked up their voter registrations and be unable to vote from home, others will be travelling while some will find it too much trouble to get out of bed. 

In general, the campaigns have been unimaginative and negative. That largely reflects the quality of our politicians and comes as no surprise at all to any of us. Neither side is really pitching a positive vision of what their favoured outcome would look like. There are no sunlit uplands to behold, only scorched earth if we don't vote their way.... apparently. 

There is however, a genuine thirst for knowledge out there, certainly among people to whom I have spoken, and a frustration that there is no balance sheet of facts on which to base a fair and measured decision. That is, voters seem to me to be treating the referendum with much more earnest reverence than are either the campaign leaders or the media. 

It has long been my view that on the day most voters will disregard the hyperbole, walk into the voting booth and go with their gut instinct. Like it or not, immigration will be a big factor in nudging that instinct. Many of our citizens see their life chances and opportunities being impacted by unrestricted immigration and the flavour and character of their homeland changing in years when before it would have happened imperceptibly over decades or centuries. Many Remain campaigners simply will not accept this but then many of them are those least affected by immigration or benefit directly from cheaper labour. I am well versed in the advantages of selective immigration just as I am of the unintended consequences of the current situation in which we find ourselves. No one is suggesting we slam the door shut forever but the current policy is simply unsustainable. Here then, are some of the facts from Migration Watch UK that will be weighing on voters minds,

  1. The current scale of migration to the UK, 330,000 a year, of which roughly half is from the EU, is completely unsustainable.
  2. As a result of this mass immigration our population is projected to rise by half a million every year – the equivalent of a city the size of Liverpool – for as long as immigration is permitted on the present scale.
  3. England is already twice as crowded as Germany and 3.5 times as crowded as France.
  4. The additional population growth makes congestion worse and adds to the pressures on public services. This comes at a time when public spending is being reduced.
  5. One in four children born in England and Wales is to a foreign born mother. The rise in the number of births has put pressure on NHS maternity services.
  6. It has also led to a shortage of school places. 60% of local authorities will have a shortage of primary school places by 2018.
  7. The UK has a serious housing crisis. Mass immigration is the main reason for the additional demand. We must build a new home every six minutes for the next 20 years to accommodate the additional demand for housing from new migrants.
  8. Population growth on this scale renders integration of newcomers virtually impossible.
  9. Three quarters of the public want to see immigration reduced and half of them want it cut by a lot.
  10. To stop the rapid rise in the UK’s population size, net migration would have to be reduced to well below 100,000 a year. It is currently at over 300,000.

The Remain campaign also makes the galloping assumption that all is well within the EU. It most certainly is not. The EU is rotten to the core and is unravelling from within as events in Greece over the weekend demonstrate. 66% of Germans are now against Merkel and there are many across Europe who see Brexit as the potential catalyst to shake down the EU and force it to get it's house in good order. Yes, we might actually be a force for good in effecting change for the wider European community. 

British citizens have not had the opportunity to express an opinion on the EU with referendums on treaties as the citizens of other nations have. This democratic deficit has created an under current of unease about Europe and the obvious implication in the here and now that a vote to Remain will be forever. I want out but then I always have and am therefore not typical. My one real concern, and this is a biggie, is that while I have no qualms about the ability of British industry to compete, I have severe doubts about the quality of our civil administrators and politicians to execute Brexit efficiently. Just as we have cocked up our participation in Europe by not sending our best people to European institutions, we could easily underplay the execution risk of getting the mechanics of leaving right. We will need to muster our very best people who will have to be at the very top of their game to get it right.