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.

The Curious Conundrum of Cypriot ATM's

Why are Cypriot ATM's throwing out so many Portuguese printed Euro's?

Since the financial crisis broke, a curious & some might say paranoid acquaintance in Cyprus has taken to checking the country identifier codes on Euro notes. He makes sure that anything issued by a PIIGS printing press gets spent first with Angela's Euros staying firmly at the back of the wallet.

Common sense he says, tells him that the percentage of notes from each country should be correlated to (a) who issues the most (b) where visitors come from.

So,  he theorises, he should expect plenty of German ones, quite a few French & Italian & lots of Greek.

When the banks closed in Cyprus, the ATMs were being topped up daily and all the notes were German. That makes sense, they flew in a Jumbo full of them.

Once the banks re-opened the composition of notes issued stabilised in a curious pattern. My acquaintance always take the maximum & does so frequently, (emptying his accounts there with a view to severing all dealings with local institutions),  thus the sample is quite good.

He usually withdraws €300 which is delivered as 15 X €20. 3 or 4 of those 15 notes will be German, 1 or 2 will be from any other Euro state, most often Greece.

Here's the weird bit. At least 10 of them will be Portuguese. Every time. It's not unusual for him to receive more.

Portugal is a small economy so shouldn't issue many notes in the Europe wide scheme of things. There are no direct flights between Cyprus & Portugal. He has have never met a Portuguese citizen there yet they’re apparently awash with Portuguese Euros with no apparent as to how or why they are getting there.

Unless........ There are some potential explanations. None of them good and I emphasise, none of them has any basis in evidenced based proof, except for the proliferation of Portuguese banknotes in Cyprus.

Summarised, they are;

Version 1 (Limited corruption)

The Portuguese are illegally printing notes way over and above what they are admitting to the ECB. Cyprus & Portugal are both “flexible,” enough that each country could find the required senior politician, banker & lawyer at each end to wash the money.

Version 2 (Full On Black Ops in which the ECB/Troika are complicit)

This is founded on the assumption that the bailout in Cyprus, and perhaps in Portugal is formally deemed doomed to ultimate failure and the banking systems in both must collapse entirely and the country/countries will exit the Euro.

It is often said that if a country exits the Euro then € holdings on deposit will be rebased to the new currency, effectively a massive haircut on everyone including those with sub €100K in the bank. It's important to note that whilst Cyprus technically has the ability to print notes the presses are private companies in France & Holland so they have no scope to pull a number like that outlined in conspiracy theory 1 above.

What is rarely if ever mentioned in the overnight euro exit scenario is that there must surely be legitimate grounds for legal challenge if a depositor can prove that they paid in physical Euros issued by a solvent state then they can say they are ineligible for conversion to the new trash currency. You can have a USD or GBP account at a bank in Cyprus. Nobody for a second suggests that those would be compulsorily converted into CY£, so intuitively it'd be equally wrong to suggest that an account full of German Euros should be converted into a less good currency. So they need stats showing that a high % of the Euros people pay in are from a less good issuer, (perhaps the one that the ECB bounces on the same day that they trigger Operation Olive Fire). Perhaps not even this. They know full well that everybody in Cyprus is emptying their accounts & filling home safes with notes. Perhaps they just want to be sure that these cash stockpiles are largely denominated in low quality issuer paper so when people show up after Euro exit they are holding Escudos not Deutschemarks and so they don't escape the devaluation haircut.

Paranoid loony tunes fool or someone who has stumbled on something which although might be correct optically, with so many box fresh Portuguese printed notes coming out of the ATM’s, nonetheless has a very pedestrian explanation? If the answer was more nefarious it does seem to be a very unsophisticated way of approaching a challenging problem.

It's probably nothing but I'd be interested to hear any input.