On euro weakness and capital flight out of the euro zone

The large increases in Target2 imbalances at the heart of the euro zone’s banking system are widely considered not just a risk to national governments in the event of a eurozone breakup, but also a sign of capital flight.  We have seen the definitive proof that bank deposits are leaving Greek banks,winding up in German institutions. In my view, this is the real risk for the eurozone. But the risk could also be for the euro zone as a whole and the question is how to identify evidence that a run on the euro has begun.

For full coverage of why the bank run issue exists, see my weekly post from June 29 on the EuroTARP. Now, the issue is capital flight from the euro altogether.

Here is the case Marshall Auerback put to me when we were discussing the Spanish bank situation. He said that the delay in the German Constitutional Court ruling was ominous and points to further difficulties in getting any kind of debt mutualisation or pan-European deposit insurance through Europe, meaning that bank runs will continue.  In Marshall’s view, recent weakness in the euro exchange rate suggests that the problem has intensified and that we might be seeing outright capital flight out of the euro system. 

A weaker euro is good for the euro zone in promoting exports, particularly for the periphery. But euro weakness caused by capital flight means that credit is contracting within the euro system and that is overwhelmingly negative for growth. Marshall told me that the fall in interbank lending is another symptom of this.

Now I have said many times that the fundamental case for a weaker euro is clear. As such there has been huge speculation in the Fx market, most of it euro-bearish. Remember all the calls for Euro-dollar or Euro-swissy parity last year? The result, Marshall says, has been a persistent and large speculative short position in the euro futures market on the Chicago mercantile Exchange. If one correlates the speculative short position with the Euro-dollar exchange rate, the speculative selling pressure should have taken the euro below its recent 1.19 low months ago, Marshall told me. Instead, the euro has traded mostly in the high 1.20s.

But now, the euro is moving. In fact, you can look at When real money market participants recognize the extent and gravity of the bank run and its dire implications for the ECB, Europe’s capital outflow would intensify. If so, the euro should fall despite an unprecedented speculative short position. Moreover, the ECB’s decision at its last meeting to stop paying interest on deposits has caused some American money market funds at Goldman Sachs and JPMorgan Chase to close to new subscribers. I recently spoke to max Keiser about this, telling him it was the right thing to do to protect those funds from losses as fewer European commercial paper issues are eligible for investment due to the downgrade of euro banks. That tells me that real money investors are going to start leaving the euro in droves. This will put heavy selling pressure on the euro in conjunction with the speculative short and the deposit flight activity. There is the potential for a serious move in euro exchange rates, but one that sucks credit and bank deposits out of the euro system. That seems to be happening now.

As Marshall told me, the last "euro summit produced a pop gun and not a bazooka. There was a short covering rally in the euro, but it lasted only two days. Within a week the euro had given up its post summit gain. Contrary to my expectations, there was no bazooka-like plan for the ECB to ease beyond expectations. The euro has fallen anyhow."

Marshall also believes this action reflects an intensification of Europe’s capital outflow. And he has seen net foreign assets at the ECB falling very sharply since the beginning of May. he continued, writing:

This suggests that the capital outflow from Europe has been greater than is generally realized and that ECB intervention has been in part responsible for the resilient bid in the euro that has kept it trading in the 1.25 or higher range despite a record spec short position. The recent action in the euro suggests the capital outflow from Europe may be intensifying because market participants realize… that the odds of a euro exit by one or more countries are increasing and political obstacles will probably prevent an effective policy response like deposit insurance to arrest Europe’s bank run and capital outflow.

Given the prospect for policy paralysis ahead, we should expect a continued capital outflow. That outflow should strain the recent efforts of the ECB to retard depreciation of the euro.

The current leg down in the euro probably has further to go.

As I hear more about this, I will send you my thoughts.

Well wishes.