The Euro and Sovereign Default
The G20 is a club for the world’s largest economies. 55% of the current membership have historically defaulted on their debt. Spain has on 18 separate occasions since 1550, Greece 5 times since 1820.
In the light of history it appears that the decision by the Basel Group to treat Sovereign Debt as risk free was a big mistake. It is this which enabled under capitalised French and German banks to lend massively to Club Med members of the Euro. With low interest rates, easy credit, asset price inflation and no exchange rate risk, the incentive to restructure pensions, subsidies and the retirement age did not exist. There was no incentive to be like Germany. And so something will have to give. The ballot box will create the inevitable: it is just not possible for Greece to meet its obligations, they have already asked for an extension of the bailout plan to 2017 and the new Finance Minister is under intense pressure to renegotiate the terms.
It would appear that a Greek departure and default is containable, possibly Portugal too, but not the others. Be reminded that Greece was barred from international borrowing for 110 out of the past 190 years!
The break up of the Euro is inevitable, the North will not behave like the South and vice versa. Greece first, by the end of this month(!). Then in 2 years Spain and Portugal. Italy to follow in year 3. By 2017 there will be a Nordic Euro, including France. This will be driven by the ballot box, with the Club Med voters choosing less austerity and the Nordic voters choosing less financial support for the South. Watch for the behaviour of Finland, they could be the first Nordic country to leave.
The money supply is contracting in Club Med as high net worth individuals shift their deposits into German and UK Banks (one of the reasons sterling trades at 1.28 and the yield on German, Danish, Dutch and Swiss bonds is negative i.e. investors are paying to be safe). With monetary contraction, fiscal tightening, low or no growth is inevitable. If you trade with any Club Med countries, do not be overexposed, know who they bank with, know their credit history, and chase debtors hard.
At the time of writing (July 20th), sovereign bond prices have risen a little based on the market view that European leaders are creating a solution. All that has happened is this; there may be a Europe wide bank supervisor by the end of the year. Bailout funds can go straight to banks (this is not debt mutualisation). That’s all folks! Another crisis is just around the corner. The Bank of England has calculated that UK Banks have sufficient capital to absorb writedowns on European sovereign debt, but it would take them back to 2008 levels.
And then they would have to start again.
British Banks
I can remember trying to explain unsuccessfully the behaviour of LIBOR from 2008. I never considered the possibility that it was being rigged. Stupid Boy.
LIBOR is the rate of interest which banks lend to each other to balance their books each day. It is the basic price of liquidity and from it almost all bank lending is priced. At 1100 hours 22 Banks are asked what price they can get wholesale money from the market.The top two highest and bottom two lowest are taken out and the remaining averaged. Because LIBOR is the determinant of $350 trillion debt instrument prices, any movement out of line with expectations results in big gains or losses for Investment bankers.
I hope that recent events will cause the Government to push back on the Banks and insist on complete separation of Investment and Retail with separate share listing. Yet again the cultural problem is the infection of solid, honest, decent retail bankers by the trading mind set from the casino division. I very much doubt Barcap could survive without the retail banks’ deposit base. British banks have spent £95 million on financial PR over the past year to waterdown the Vickers Repot proposals. For example the Government has agreed that they can sell financial derivatives to SMEs (madness).
I am sure there is more to come on rate fixing, stitching up customers (the Muppets), and total self interested behaviour. If the system privatises the profits but nationalises the losses, such behaviour is almost inevitable. We must change the system and quickly because the reputational damage is global. Bob Diamond just doesn’t get it: a fish always rots from its head. The big law firms will be gearing up for proliferation of class actions against banks which will run for years.
The Bank of England has told UK banks that they can reduce their liquidity buffer and that it will accept lower quality bonds for liquidity provision. This could release up to £300Bn for new lending. But given the uncertainties from Euroland, I doubt if more than £30-£50Bn will become new credit. The announced increase in QE by another £50Bn will enable the Government to fund its debt issuance at current yields. So no change in interest rates for a long while yet, but more QE will not increase the supply of credit, it will just allow the Government to borrow another 130Bn next year at interest rates below 3%.
The Global Economy
It is rapidly slowing down. The most recent purchasing managers index is at 50 which is the tipping point. Western economic policy is tight-ish fiscal policy (with Government’s trying to limit their borrowing) mixed with extremely loose monetary policy. And each country is exhorting its industry to export more. Very loose monetary policy is like pushing on a piece of string. It has prevented a global depression but that is it.
The latest news from China is that the demand for commodities and machinery has not been about end use. Anything with a monetary value such as commodities is being used collateral to secure loans which are then fed into the shadow banking system for higher returns. It follows that if commodity prices collapse so will the collateral. This will create a financial crisis, forced stock liquidations and further falls in price. Be aware that China is becoming more unstable. The Australian Dollar and Brazilian Real will weaken as a consequence of a commodity price slump.
The latest figures from China suggest that at 7.3% real growth the economy is at the target level of growth set in the new 5 year plan. As always the GDP numbers are a political statement. The consumption of electricity has not increased for a year now. This suggests much lower growth. GDP and the demand for electricity move in line. For example UK electricity demand adjusted for the weather (!) is down 2% over the past year, and this is almost in line with our economic output.
Brazil is only just growing as export volumes, particularly to China have fallen sharply. The USA is losing the momentum established earlier in the year and Europe as a whole is at Zero growth (strip out Germany and it’s in recession).
As forecast the oil price is at the minimum target price of $100 and it will not fall much below this for long.
NB - I now expect a mild global recession next year.
Here is why:
The Euro debt problem can only solved by write down, inflation, more debt or growth. It is infecting boardrooms around the world. Finance Directors will hoard even more cash. QE doesn’t increase the capital base of a bank. Writedowns reduce it and there will be a growing number of these. As the velocity of global money falls so will global GDP.
Is there a solution? Yes. In Europe the slate is wiped clean as countries agree to write down what they are owed. Germany would need to write write down about 600 Billion Euro, but the total writedown would be around 1.2 Trillion Euro.
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