Adjustment Needed Now

By Claus Vistesen

(see source of image at end of post)

I have recently spent a few days in New York talking to clients as well as sneaking in a bit of marathon watching and a visit to the Guggenheim museum. Flying across the big pond also means that there is plenty of time to catch up on movie watching. I opted for the action pack on the way out and went for a bit more intelligence and depth on the way home.

I especially liked the last movie I saw, the Adjustment Bureau (The AB), which stars Matt Damon (as David Norris) and the lovely Emily Blunt (as Elise Sellas). The AB is an interesting metaphor for fate and the concept of and the extent to which you are your own master or whether there is grand plan that we are all bound to follow. The movie works mainly because of the interaction between David and Elise. Especially the second chance meeting (in the bus) between Elise and David after the latter had been riding the same bus for 3 months to try to see her convinced me that these two persons were meant to be with each other. Any grand plan that the illusive Chairman and his caseworkers are trying to enforce in order keep these two people from being together is surely unfair and wrong.

The premise and drive of the movie then becomes Damon (David Norris) and Blunt’s (Elise Sellas) fight against the fate imposed on them by the Adjustment Bureau. And I would argue that anyone with but a shred of romantic fiber will be cheering for David and Elise on this one.

Does this sound familiar? I think it does. And as I thought about the movie, I realised that it mimics the attempt by eurozone policy makers to force through a grand plan of monetary cooperation despite obvious signs this is not working. 

Enter Monti and Papademos. You could hardly find a better expression of the EU’s attempt to keep things according to plan than the appointment of two eurocrats as leaders of Italy and Greece respectively. On the face of it, you would think that their appointments have been a success. Both have recently won approval in parliament for pushing through just about any agenda that their new government may see fit.

Quote Bloomberg

Italian Prime Minister Mario Monti won a final parliamentary confidence vote, granting full power to his new government after pledging to spur growth and reduce debt in the euro-region’s third-largest economy.


Greece’s new government unveiled a budget for 2012 with a deficit shortfall dropping by almost half, thanks to pension and wage cuts and a Greek debt swap that will slash interest costs. (…) The fiscal plan, which will be approved by the Greek Parliament before a meeting of European Union leaders in December, is designed to regain the confidence of creditors and secure resumption of international financing. Prime Minister Lucas Papademos, appointed last week, is racing against a three- month deadline until elections to secure international loans and avert a collapse of the economy.

Look a little closer however and you will see that the market is still calling the shots, as focus has swiftly shifted from Italy and Greece over to Spain where borrowing costs last weeks reached all time highs. It seems that as one hole is plugged and the plan put back on track, another problem emerges and throws it off track again.

In Greece, for all the talk of Papademos preventing collapse, it is important to emphasize that he is there mainly to manage a default process.

Quote Bloomberg

The Greek government started talks with banks on the terms of the voluntary debt swap that is part of the country’s international bailout agreement, the Finance Ministry in Athens said.The debt swap — part of a second rescue package for Greece — aims to put the country on a path to cut its overall debt load to 120 percent of gross domestic product by 2020. The discussions in Athens are expected to take weeks to conclude, a European official said today on condition of anonymity.

120% in 2020, while probably realistic is still too high for Greece. And the issue of non-paying CDS will continue to complicate matters. The point is not so much the obvious issue that a 50% haircut can never be considered voluntary, but two additional factors. The first is that there is still considerable risk of Greece backsliding, even with Papademos at the rudder. And as the ECB have rejected to participate in any restructuring with its bonds (implicit seniority), any further haircuts will have to fall on private creditors. Thus, any further haircut from this point and we are looking at a near full wipe-out. Second, if the sovereign CDS market turns out to be a red herring, it is likely to lead to a sharp re-pricing of all exposed sovereign risk as potential buyers will realise that the only real insurance they have is to pay a lower price (i.e. demand a higher yield). Let me re-emphasize. Putting together a deal that gives banks a 50% "voluntary" haircut so that CDSs on Greek debt are not activated only to string together, on the same meeting, a deal to allow the EFSF to issue CDSs on Italian and Spanish debt is amazing to me.

In Italy, trend growth is essentially 0% if not negative. If you factor in the government’s proposals for austerity from here to 2015, the debt snowball will be difficult to avoid. It is unlikely that Italy’s new government will provide stability as the task facing them is impossible without financial help. Italy is likely to be asking for support at some point and here it is quite unlikely that the IMF or EFSF will be able to step in. This leaves the ECB which is already being forced into the fray by market conditions, pushing up Italian yields.

There is strange focus on primary surpluses in Italy and the fact that the country managed to bring in the debt to GDP ratio in the 1990s due to ongoing primary surpluses. It is precisely the high interest rates/low growth environment which is choking of growth. Eliminating interest rates from the analysis makes no sense at all. A simple rule of thumb states that if your nominal growth rate is below the weighted average nominal rate of interest on your debt, then the debt snowball will roll. Obviously, fiscal austerity undermines growth and thus exacerbates the debt snowball. Frontloading fiscal austerity when yields are rising and growth is going down will end in a vicious circle a la Greece.

To me, the most significant development in the past month remains the extent to which the grand plans unveiled at the Euro summit have already moved into oblivion. As I noted at the time, the plan to use EFSF capital to provide first loss insurance on Italian and Spanish debt was always going to be a disastrous use of scarce capital. Essentially, the banks were rolled in at the eleventh hour to be informed of their haircut and they are now reacting accordingly. I continue to believe that the most important objective must be to recapitalise eurozone banks to avoid the credit crunch from spiralling out of control.

A severe credit crunch is developing in Europe with Morgan Stanley estimating the total shrinkage of eurozone banks’ balance sheets to the tune of 1.5 to 2 trillion euros. This is between 15% to 20% of eurozone GDP (2010 values).

There are three components here.

  • When sovereigns’ funding costs increase, it becomes impossible for local companies and banks to finance themselves in the short term liquidity markets as well as long term funding becomes more expensive. Many European banks are essentially dependent on the ECB’s liquidity window for survival.
  • Banks prefer to shrink their assets rather than raise new equity/debt because the latter is almost impossible at this point. We essentially need a euro-TARP to solve this. This forced shrinkage of the asset side is the main transmission mechanism of the credit crunch to the real economy.
  • Deposit/funding flight from the weakest banks and countries. Essentially, the market can and will discriminate and the weak will get weaker.

I am not getting paid by the European Banking Association. I am merely trying to convey the idea that when you ask banks to take a significant hit on the asset side, while at the same time they remain unable to adjust the liability side, a credit crunch is exactly what you end up with.

This is especially important in Eastern Europe, as the region faces significant roll over and financing risk in 2012. Hungary and Ukraine will need to start paying back the IMF loans and Hungary faces, to boot, significant funding risks in the banking sector. Hungary is in a very tight spot because the foreign banks are essentially shutting down lending due to the fact that Hungary has pushed through a deal which allows homeowners to pay back CHF mortgages at a, for them, favourable exchange rate.

Hungary is caught in a vice, which perversely forces the central bank to raise interest rates in times of volatility to protect the currency, and thus Hungarian borrowers of foreign currency as well as to help keep inflation in check. Whether the central bank will move in with aggressive interest rate hikes (as in the 300bp hike in 2008) is questionable. Outright intervention is probably more likely. The sad irony of Hungary’s situation is that, just as the country faces the pressure of paying back the first installment of IMF loans received at the initial phases of the crisis, there is talk about the fund coming back in. Details are sketchy at this point, but Morgan Stanley and others suggest that such talk may already be ongoing.

In addition, Romania and Latvia will come off the IMF/EU taps and return to market based financing, which will further put strains on supply, even if these economies are small. Essentially, many economies and corporates in CEEs have pushed forward financing to 2012 in hope of better times. The problem is however that the good times seem to be somewhat further away than initially expected and any economic agent having postponed tough financing decisions to 2012 in hope of relatively more calm markets is about to be disappointed.

Adjustment Needed?

We are then back to square one with ECB bond buying and the Franco/German disagreement about this very question representing the main issue which holds back markets. It is furthermore important to emphasize the underlying current here in terms of global credit markets as a whole. Almost all credit spreads are widening and wholesale funding markets are virtually non functioning which means that banks, especially in Europe, remain dependent on the ECB’s funding window more than ever.

In practice, the ECB is already buying considerable quantities of Spanish and Italian bonds, and this will continue until there is a credible plan on the table for a eurozone-wide recapitalisation of the banking sector.

For the chairman and the case officers it gradually becomes clear that it is too difficult to keep David and Elise from seeing each other and the archives are consulted which reveals an interesting fact. In earlier versions of the plan, Elise and David were meant to be together and it is concluded that this is probably one of the reasons that the plan keeps deviating from course.

As a result, the case officer originally tasked with keeping David and Elise is taken off the case and Thompson, aka the Hammer, is brought in to handle David’s "adjustment". As he confronts David with the irreversibility of the plan, he conveys the arrogance of an architect unwilling and unable to deviate from the original set course. In this sense, Thompson displays the same inflexibility as European politicians in their claim that the world would unravel if the plan is not strictly followed.

As Dan accepts Thompson’s argument that he and Elise are not meant to be with each other, if only because Thompson promises to destroy Elise’s dancing career, he leaves Elise and all seems lost. Yet, in the frantic closing stages of the film, as David takes a final leap of faith running the risk of being "reset", we learn that the idea of adjustment is a double edged sword. Things can be adjusted according to plan, but the plan itself can also be adjusted.

There are very good reasons why events keep on deviating from plan in the eurozone. It is misleading when we are told that it would be a disaster if the status quo is not maintained in the eurozone. Indeed, it would be a disaster if it is. There is plenty of evidence and good arguments as to why the eurozone in its current setup was always going to fail and why considerably adjustments would need to be made as we moved forward. Such adjustment were never made however and all we we were told was that the convergence would happen by default as time passed.

I am not, and have never been, advocating a break-up of the eurozone, but it seems to me that obvious decisions are being avoided because they are deemed to conflict with an underlying plan the meaning of which I find difficult to see. An adjustment is needed in Europe – and, like with Dan and Elise, any adjustment should be to the plan itself.

Source of image are and Universal Pictures. All pictures above are courtesy of and Universal Pictures and specifically this entry. The Adjustment Bureau is produced by Universal Pictures.

This post first appeared on Alpha.Sources.CV.

1 Comment
  1. Anonymous says

    Some how I doubt that the east European nations will be able to get back to the credit markets next year. The problem will be that they might have new problems, with the rest if Europe entering recession. Then losses in Eastern Europe will reduce Central European banks capital. Then there will be a retrenchment by those banks who have invested in the east. The Greek bank’s problems will mean that Cyprus and Romania will have problem banks, which will impact those economies. There simply is insufficient recognition of the links between banks and who will be effected by politicians, 

  2. Anonymous says

    Some how I doubt that the east European nations will be able to get back to the credit markets next year. The problem will be that they might have new problems, with the rest if Europe entering recession. Then losses in Eastern Europe will reduce Central European banks capital. Then there will be a retrenchment by those banks who have invested in the east. The Greek bank’s problems will mean that Cyprus and Romania will have problem banks, which will impact those economies. There simply is insufficient recognition of the links between banks and who will be effected by politicians, 

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