The Irish stress tests and euro zone options: monetisation, default, or break-up
The results of the Irish stress tests are going to be released this afternoon at 430PM Irish time. I will be talking about the implications for investors in European markets on CNBC’s Power Lunch show.
I think one has to be cautious about the sovereign debt of any of the periphery countries at this point. I also think haircuts on Irish bank debt are coming as well as a Portuguese bailout. But there are a lot of unsolved issues concerning Spanish banks and as well as the German, British and French holders of Irish bank debt. Here’s the background to what I will say on the show.
Four months ago I wrote a post outlining three options for the euro zone: monetisation, default, or break-up just after the Irish bailout. Markets were disappointed by the terms of that package as it showed Europe was not dealing with the fundamental solvency issues that have created the European sovereign debt crisis. Instead, they were treating this as a liquidity crisis. And that has permitted the liquidity crisis to spread beyond Greece and Ireland to Portugal.
Will the Portuguese be the next domino?
At this point, Portugal is probably headed for a bailout. The government has collapsed and bond yields are trading at post-Euro high spreads to German debt. In fact, credit default swaps suggest that Portugal is one of the likeliest governments to default on its debt obligations. The situation for Portugal is in a word – grim.
Portugal faces a coupon payment of 700 million euros and a debt maturity of 4.3 billion euros in April followed by another one in June of 2 billion million euros in coupon payments and 5 billion euros in maturing debt. Just as the Greeks and the Irish before them, the Portuguese government continues to insist neither is it seeking nor will it need a bailout. However, the only real bidder for Portuguese debt is the ECB. Market participants are shunning Portuguese debt and we now see what has happened to Portuguese debt yields without that lender of last resort.
FT Alphaville reports that yields on Portugal’s 10-year bond have now breached LCH Clearnet’s ‘margin call’ spread of 450bps, meaning they are officially in the junk category where increased margins for trading are activated. Apropos junk, the ratings agencies are still reactive on this. S&P has cut Portugal’s sovereign credit rating to the lowest investment grade level, BBB-, and noted it will downgrade Portugal further if it does not receive a bailout.
Win Thin of Brown Brothers Harriman says:
S&P cut Portugal one notch from BBB to BBB-, and comes just five days after it cut the rating from A- to BBB. Did things really materially change over the past five days? It’s time for a reminder of what the agencies are capable of doing when they have been caught behind the curve. Indeed, we haven’t seen them flailing this badly since the Asian crisis, when S&P took Korea down by four notches on December 22, 1997 from BBB- to B+.
BBH’s Developed Country Risk Index rates Portugal BBB+. But, clearly, the ratings agencies are in crisis mode because they want to be seen as ahead of the curve instead of behind it. Win says: "Rating agencies totally missed the boat on the peripheral euro zone, and are now trying to play catch up and perhaps even overcompensate to the downside." Their cuts will create problems as the next step puts Portugal in junk territory. And that almost certainly means curtains for Portugal as their potential investor base would dwindle even further. The ECB has not been buying Portuguese debt of late either. So Portugal is headed for a bailout; count on it.
What about Ireland?
Well, it is likely that the State will nationalize the remaining big Irish financial institutions, Bank of Ireland and IL&P (Irish Life and Permanent). As Ireland has received assistance, the question now goes to Irish government default and/or bank haircuts.
Let’s put the Irish situation in context, however. Here’s what happened.
The Irish economy grew very fast even before the property bubble spiralled out of control. When the euro was introduced, the problem was:
an unbalanced Euroland in which Germany and the Netherlands exported and Spain, Portugal and Greece imported, running up enormous current account imbalances in the process. Take a look at the capital account figures in the financial sector balances from this FT chart.
These imbalances are a direct result of a monetary policy that was geared to slow-growth core Europe. The result was an enormous property bubble in Spain and Ireland in particular. It’s not as if a robust regulatory environment could have overridden these forces either; the Banco de España, Spain’s central bank, is widely credited as having run one of the more solid regulatory regimes in Euroland. Yet, this did not stop a runaway property bubble from forming and imploding.
Moreover, what these two charts also point out is that, in Spain and Ireland, enormous property busts turned what were fairly large government budget surpluses in 2006 – the largest in the euro zone except for Finland – into an enormous government budget deficit by 2009. The Netherlands is the only other country besides these three that had a surplus in the euro zone in 2006. I have shown you the other crisis country’s budget numbers and Germany’s over the decade. So here are Ireland’s.
Surpluses for every single year to 2006. It is inaccurate to say "we [Irish] added to the mess by managing our public finances like drunken sailors" as Shane Ross has done. The numbers do not support this in the least. But this is the sort of self-flagellation you hear in the Irish press all the time.
The flip side of the current account problems were capital flows that saw German money invested in Spanish and Irish banks, in effect fuelling the property bubbles in those markets.
That’s all in the past, however. Ireland’s low debt and government surpluses have turned into a huge debt burden and massive government deficits because of the banking crisis – this in spite of, or should I say also because of, fiscal austerity. The Irish banks have recognized a huge slug of bad debt from the property developers. The question now is regarding residential property mortgage arrears and recognizing residential property losses.
When the banking panic happened in September 2008, Ireland issued sweeping deposit and bank debt guarantees. It was the bank debt guarantees that were the problem because of the size of Ireland’s financial sector relative to the domestic economy and government balance sheet.
I see a bit of historical revisionism going on here. In November, I wrote:
I have to point out again that the Swedes also gave bank debt and deposit guarantees when their banks failed in the early 1990s. So, despite everyone’s falling all over themselves to pinpoint this as the crucial reckless error by the Irish, there is precedent here. You should understand that the key difference is private sector debt levels in Ireland are some 700% of GDP because of the enormous size of the Irish financial sector. It is the Icelandic problem, not just the deposit guarantees, or even the debt guarantees, since other euro countries also guaranteed deposits (important that you see here).
P.S. – And yes, I talked about the bank debt guarantees here as a critical error as far back as November 2008 but only in the context of the large size of Ireland’s financial sector. I recommended deposit guarantees and think that partial deposit guarantees were a must in Europe in 2008 to stop bank runs. Moreover, other countries have the too big to rescue problem as well. It’s not just Ireland.
Everyone has patted the Swedes on the back for their successful 1990s bailout and crisis resolution scheme. That scheme was very similar to the present Irish one. The major difference is threefold:
- The Swedish banks were not as large relative to the domestic economy. The Swedish government could credibly backstop the banks and the debt guarantees.
- The Swedes have their own sovereign currency. That means currency depreciation helped the Swedes tremendously.
- The backdrop for global growth in the aftermath of the Swedish banking crisis was more favourable than it is presently
Take a look at this Chart of the Swedish Krona (SEK) to the US Dollar (USD). This covers the entire period from when Swedish central bank head Urban Bäckström took over at the Riksbank to when he wrote his review of the crisis in 1997. (See my post The Swedish banking crisis response – a model for the future? from August 2008).
The Swedish banking crisis began during the disruptive ERM crisis that culminated in the UK’s exit from the European Exchange Rate Mechanism of fixed exchange rates on Black Wednesday. The Swedes saw an enormous appreciation in the krona which helped to precipitate a banking crisis. But after Black Wednesday and Sweden’s attempt to fix the krona to the euro’s predecessor ECU by charging 500% for overnight money, the krona depreciated against the US dollar by some 40%. That’s an enormous move in a 15-month time span. That’s not going to happen in Ireland. In fact, the ECB is talking about raising rates – making the Irish situation worse. Irish residential property losses will increase under that scenario.
There is no way the Irish economy can go through austerity, which lowers consumption demand and economic growth, while paying the 5.8% ‘bailout’ rate of interest it has agreed to without ballooning its debt burden. The Irish are currency users. They have no sovereign currency, so it’s not a matter of printing up a gazillion Irish punts to ease the crisis. The ECB has made it plain that a full scale monetisation route is not going to happen unless we get an existential crisis (likely caused by a Spanish sovereign crisis). Default is the only way to ease this burden. And so the question becomes who will take the losses: Irish taxpayers, foreign bank creditors in Spain, Germany, the UK and France, or sovereign debt creditors. It’s as simple as that.
Right now, we are fighting over who will eventually take the pain. The previous Irish government sided with creditors. They were ejected for this. The new government has made clear they are less likely to follow in this path. Increasingly, it looks like bank bondholders will share the pain. The Guardian reports:
Permanent TSB, the largest mortgage lender in the country, which is not covered by the September 2008 bank guarantee scheme, could be used to set a precedent for foreign lenders to accept losses rather than leave the burden with Irish finance houses and the state.
Clearly, the first round of European stress tests were not very stressful since the Irish banks passed and we subsequently got the Irish bailout. There are doubts about how stressful these tests are as well. And that should make investors skittish as to whether these tests will draw a line under Irish sovereign and banking problems.
If these stress test are not credible, Ireland will have problems that could reverberate to Spain and Portugal. And let’s not forget the Irish bank deposit runs are still ongoing.
So that’s Ireland.
What about Spain?
[S]peak to economists, advisers and even ministers in Madrid and two terms will pop up within a few minutes. The first is Pigs – the acronym used by lazy financial traders to refer to Portugal, Italy, Greece and Spain (although nowadays the i is sometimes taken to mean Ireland). "I find it offensive and pejorative and useless," one senior and otherwise softly spoken central banker told me.
It’s actually worse than that. Being bracketed with three other countries in southern Europe has helped pull the Spanish into a financial-market conflagration that has lasted the best part of 18 months, and forced the policy-making elite into a series of U-turns and crises. The economy has some huge long-term problems but, even if you squint, the similarities with the other peripheral nations aren’t especially close. Unlike Portugal, Spain has enjoyed decades of economic development. Unlike Italy, Spain ran its public finances before the crisis with iron discipline. Unlike Greece, there are no question marks over the official budget figures. "I don’t mind the term Pigs," José Manuel Campa, the deputy finance minister, said. "But I think it should be singular – Spain isn’t part of any southern European problem."
–Nightmare for residents trapped in Spanish ghost towns, The Guardian, 28 Mar 2011
The Spanish are looking to decouple from the periphery. This is unlikely to happen unless they get their banking sector in order. Just today, the FT reported that the Banco Base merger deal has collapsed that was one of the schemes used to merge weak Spanish savings banks with stronger brethren and have the combined entity recapitalised with private sector or government money. This is a bad sign.
These deals are much like the Lloyds – HBOS deal pushed onto Lloyds shareholders after Lehman filed for bankruptcy and the Japanese bank mergers of the 1990s. You could look at it as a socialisation of losses that avoids taxpayers holding the bag. The problem with this is that the outcome is dependent on asset prices and writedowns. If asset prices do not fall further, credit writedowns will be minimal. If asset prices do fall further, the capital base of the combined bank will be destroyed and much more capital will be required.
The Spanish banks have not written down their mortgage loans. So there is a large amount of potentially bad debt already on the books of these institutions. Marc Chandler writes:
Many observers suspect that Spanish banks have yet to mark-to-market their property and construction loan portfolios. The cajas have taken control of 23 bln euros of property after defaults and some land prices have fallen by as much as 80% over the past four years. The central bank estimates that Spanish banks hold around 320 bln euros in property assets and (real estate and construction) loans.
The Spanish government has been trying to solve this by encouraging private investors to pony up for the banks as Tim Geithner was able to successfully encourage investors to do for U.S. banks. The Spanish central bank has said the banks need 15 billion euros in capital. The rating agency Moody’s puts the figure at 50 billion. Some private sector estimates run to 100 billion euros. This means the government will have to step in or allow these banks to fail. Investors see the mounting losses in Ireland where there has been a greater recognition of bad debts and are frightened. They see the potential for more pain down the line. And Spanish banks are also exposed to Portuguese debt as well.
From an investor’s standpoint, this means caution is warranted when it comes to Spanish debt because there is the potential for large contingent liabilities from the caja bailout. When Portugal gets its bailout, all eyes will turn to Spain. The country is bigger than Greece, Ireland and Portugal combined. So when thinking about the three scenarios: monetisation, bailout or default, in Spain’s case, a bailout is probably not going to happen.
Handicapping the scenarios
As I wrote in November on the three scenarios, "[m]y view is that some combination of monetisation and default is the most likely scenario for Europe." We have already seen the bailouts in Greece and Ireland. Given the debt maturity and coupon issues in Portugal, the liquidity crisis there will reach a point soon where a bailout is also necessary. In each case, the cost of a bailout is austerity and internal devaluation along the Latvian model of crisis resolution. The question is whether these countries can successfully do this with debt-to-GDP levels and unemployment so high. The cost would be great and social unrest would be likely.
My sense is that the cost will be too hard to bear and that defaults are likely. In Greece’s case, it will be a sovereign default. In Ireland’s case, a bank debt restructuring is likely. Beyond that, there are many potential scenarios. Portugal has a debt-to-GDP ratio about where Germany’s is. There is no reason they can’t make it, if the government and Europe choose the right path, one less dependent on austerity and more dependent on growth and temporary liquidity. Spain needs to steer clear of getting too close to its cajas. It cannot afford to pump them full of taxpayer money and take on contingent liabilities as the Irish have done. This would cause the Spanish to re-couple to the periphery and then the euro zone would be in an existential crisis.
Greece has a solvency problem. The Irish banks have a solvency problem that has become the Irish government’s solvency problem. Portugal and Spain have liquidity problems. The austerity and the defaults will be negative for growth in the periphery but will also boomerang to infect the euro zone core. Growth across the euro zone and in the UK will be weak. That’s my take on the situation.