I have been reading press accounts of the GM decision to back out of the Opel/Vauxhall sale to the Magna/Sberbank consortium from various countries. There are a lot of different perspectives on this event in the U.S., Belgium, Spain, Germany, Russia, the U.K and elsewhere, because a lot of players are involved.

The conclusion I come to is that economic nationalism is the driving motivator behind much of what you read. To the degree, we continue to experience a soft global economy, this should be seen as a warning of how individual actors will respond in future.

Easy decision to keep Opel

GM’s decision to keep GM Europe is fairly straightforward in my view. The cars and technology in GM Europe is something General Motors never wanted to part with. They only did so because of the need to raise cash in a weak economic environment. Now, things at GM (and Ford) are looking much better and GM has exited bankruptcy. There is no desperate need to sell.

Moreover, the EU was asking GM a lot of questions about the subsidy deal they struck with the German government in order to effect the sale of Opel. Other European nations, Spain and the U.K. in particular, were livid because they suspected an unfair subsidy of German jobs over Spanish or British jobs. But, it goes far beyond those two nations as GM Europe employs 55,000 people in places like Sweden, Poland and Belgium.

We saw what happened to ING, RBS and Lloyds due to the EU’s rules on competition. One could reasonably expect a similar crack down in the auto sector. Details will emerge at some juncture, but one could conclude that GM did a cost-benefit analysis in which the wrangling with the EU weighed heavily on their decision to back out of the Magna deal.

And, in the end, should we expect the restructuring GM performs to be qualitatively any different than what Magna’s consortium would have done? They too have announced 10,000 job cuts, a figure in line with what was expected under Magna’s control. So, on the surface, this looks like a net benefit for GM, a net loss for the Magna-led group, and a wash for workers and politicians.

Enter economic nationalism

But, unfortunately, that’s not how it is likely to be seen. Let’s look at it from a German perspective.  Germany’s Chancellor Angela Merkel went to bat for the Magna deal, winning what was widely seen as a measure of security for German workers at a critical time during economic weakness. This bolstered her election chances. As a result, the center-left SPD has now been replaced by the Libertarian-minded FDP in a coalition reminiscent of the Helmut Kohl days. Consider this a move to the right in Germany.

Nevertheless, Merkel has stuck with her allegiance to Barack Obama. In fact, as a result of this relationship, she was the first German Chancellor in 50-odd years to deliver an address before Congress just two hours before she learned of GM’s backing out. What’s more is the U.S. Government is the majority owner of General Motors. One would think the Obama Administration had some insight into the decision-making at GM. Either the Administration didn’t know and is being recklessly hands-off in an enterprise where it has sunk tens of billions or it did know and did Angela Merkel a disservice by not informing her of what was to come well before her speech to Congress.

So, you have an American company owned by the American government backing out of a signed agreement and potentially thousands of jobs at risk. Talk of plant closures at Eisenach, Bochum (and Antwerp in Belgium) and the loss of jobs is rampant in the German press. GM Europe’s head John Smith says, "if they like the Magna plan, they will also like the GM plan." That is not an argument likely to gain sway in a period of economic uncertainty.

The Germans are livid.  German workers have gone on strike. Meanwhile, you have the UK Business Secretary Lord Mandelson warning that the division of job cuts must be ‘fair.’ And the Spanish Opel workers had just OK’ed the Magna plans two weeks ago. This is a bit of a zoo, isn’t it?

It is every nation for itself – precisely what one would expect with a shrinking economic pie and a deep downturn.

Going forward

GM has mishandled this affair quite badly I believe. At least with the Magna deal, the Germans were in the driver’s seat. Now, all of the individual European nations are angling for their say in this matter. Yes, GM had little choice given the likely scrutiny it was under via Neelie Kroes, but it certainly could have handled the political aspects of this much better.

However, now that this situation is out, it gives us a bird’s eye view into how nations respond when a division of the spoils becomes an issue.  And what we have seen does not give confidence that a coordinated approach will prevail. I take this affair as a clear indication that economic nationalism is alive and well and very much a threat to our collective well-being.

Related posts:

• Germany gives GM a stiff arm on state aid
• GM board decides to keep European Opel unit
• German Press: Fiat to sign a deal with Opel, not Chrysler
• Germans reject Chinese offer for Opel
• GM considers keeping Opel, raising capital

Fitch, the credit rating agency, has just downgraded the sovereign debt ratings for the Republic of Ireland from AA+ to AA-.  That is two notches and is proof-positive that the ratings agencies are worried about the hole in Dublin’s finances.

If you read the Irish press this morning, it is all doom and gloom and has a lot to do with the banks and budget deficit.  It is not just about the ratings downgrades.

The EU has just released figures putting in doubt Ireland’s rosy scenario for cutting budget deficits.

The Irish Independent says:

Next month’s Budget may set the economy back further, but without it the country’s national debt could reach 100pc of output (GDP) by 2011, the EU Commission has said in a new analysis.

The Commission is forecasting a decline of 1.4pc in Irish GDP next year. But Brussels is not taking the impact of next month’s Budget into account, because the details are not yet known.

"Depending on the specific measures that are eventually implemented, a dampening effect on consumer demand cannot be excluded," the Commission says in its autumn economic forecast.

Correction

On the other hand, it says that faster correction of the economy’s problems might give more support to consumption and investment by helping confidence.

The Government’s plans include a correction of 4.3pc of GDP — around €8bn — in the Budgets for 2010 and 2011.

Unless there is a compensating boost from confidence, this could also reduce the modest 2.6pc growth forecast for 2011.

These forecasts are higher than those in the Commission’s estimates last May, but it warns of the struggle facing the Irish economy in trying to return to strong growth.

Another top headline in the Irish Independent has the OECD warning that the Irish government should not rule out nationalising banks in addition to its bad bank programme, NAMA.

The Government shouldn’t rule out temporarily nationalising the country’s banks as they may require more capital to cushion against surging bad debts, the Organisation for Economic Cooperation and Development said.

The Government is setting up the so-called bad bank that will buy €77bn of property loans from banks at a discount of 30pc. Losses on those assets may leave the lenders needing extra capital.

“Further recapitalisation may be necessary as assets are being purchased below book value,” the Paris-based OECD said in a report today. “Temporary nationalisation would have a number of drawbacks, but it should not be ruled out altogether.”

The Government has already guaranteed all deposits at banks and some of their debts, pumped €7bn into Allied Irish Banks and Bank of Ireland and seized Anglo Irish Bank.

“Substantial” banking losses are likely to be met by the taxpayer and nationalisation should only be undertaken with the “utmost reluctance,” the OECD said.

The FT’s Stacy-Marie Ishmael has a piece out doubting the maths used in NAMA, which bolsters the OECD view that the bad bank may not be enough.

So you have a trifecta of bad news coming out of Ireland: a two-notch downgrade by a major ratings agency, a warning from the EU that the economy will be weak for sometime to come and that deficits targets will not be met, and another warning from the OECD that the banking situation in Ireland is still very grave.

Quite frankly, it is not looking good for an Irish recovery at this time without the help of the IMF. This all brings me back to my question one year ago: Is Ireland the next Iceland? They will be if the EU, IMF and Irish government do not take today’s bad news seriously and take drastic action to bolster the Irish banks, economy, and government finances.

Who said the financial crisis was over? It is not.

Related posts:

• Ireland: Next stop – IMF
• Ireland guarantees bank deposits at six banks
• Irish government unveils plan to recapitalise banks
• Ireland nationalizes Anglo Irish bank
• Is Ireland the next Iceland?

At the weekend I wrote about Alistair Darling’s about-face on breaking up to big to fail financial institutions. Apparently, this was not a case of labour changing tack and finding regulatory religion, but rather of the European Union imposing its will on the British government. The EU is also dictating policy in Germany, the Netherlands and elsewhere.

The Telegraph reports:

RBS said in a statement on Monday it was in the final stages of talks with the European Commission about "some divestments not initially contemplated" to get EU approval for the billions of pounds it has received in state aid.

Selling Citizens, which has 26,000 employees, is said to be one of the options raised by Neelie Kroes, the EU competition commissioner.

She is also said to want the sale of the Churchill, Green Flag and Direct Line insurance businesses, more than 312 RBS branches in England, Global Merchant Acquiring, a card payments processing arm, and a reduction of the investment banking operations.

And RBS shares were down as the effects of the EU’s dictates became clear for that institution. Job losses were the most negative storyline and unions are expected to resist these moves vigorously. But asset sales were also part of the equation.

The Guardian reports:

Royal Bank of Scotland’s woes deepened tonight after unions condemned 3,700 branch job cuts as "absolute madness" on the eve of an announcement of a dramatic restructuring of the bank imposed by Brussels.

RBS is tomorrow expected to admit that it is being forced by the EU to make major commitments to cut back the size of its balance sheet and sell off some of its highest profile businesses in return for more than £40bn of state aid.

The bank acknowledged for the first time today that the EU was demanding more draconian measures than it had first envisaged, driving RBS shares down sharply. They closed at 38.65p, down 8%, giving the taxpayer a paper loss on its investment which breaks even at 50.5p share.

Analysts were concerned that the new chief executive, Stephen Hester, would need to redraw his business plan which is only eight months old, and that the profits of the bank could tumble by as much as £1.5bn a result of the EU’s intervention.

As the Treasury prepared to admit it was putting another £25bn into RBS to take the taxpayer’s stake up to 84% to help it participate in the government’s toxic asset protection scheme, unions reacted angrily to the front-line job cuts.

So, far from appearing forward-looking, Labour look quite reactionary here. Not only are they having to bend to the will of Neelie Kroes in Brussels, they also are being forced to top up their stakes in the banking black hole even while job cuts are being made. This is not the sort of thing that is likely to lead to more votes at the ballot box. (By the way, why do the British media insist on always using this picture of Darling in articles. I find it pretty comical.)

The UK is not the only country coming under pressure for state subsidies (a weak form of protectionism). In the Netherlands, ING was forced to break in two and reduce its balance sheet because of the EU’s policy on subsidies. In Germany, Commerzbank (in large part because of sick child Dresdner) is also going to have to reduce the size of its balance sheet. Commerzbank reported more than 1 billion euros in losses today, a sum which was a negative surprise (thinking back to Halloween, it was more trick than treat). Expect asset sales here too. I know that Fortis and Natixis are other institutions with problems. What is the EU doing there?

The situation is very fluid right now and many details are expected to emerge in the coming days.  Expect the EU actions to put pressure on the U.S. which is also subsidizing its banks in an anti-competitive way.

Related posts:

• European banks have hands out for more capital
• European banks: still undercapitalised
• $5 trillion to go on balance sheets again?
• No one gets a bonus at Commerzbank and no dividend either
• The Germans get tough with the state banks

I used to be a European High Yield guy. I was there when the market first took off in the late 1990s on the back of telecom plays like NTL or Telewest. I was also there when the Russian devaluation and default shut down the market. And I remember how the market tanked when the Tech Bubble burst and those 7 and 8 times EBITDA and 0.9x coverage ratios were not met, defaults skyrocketed, and investors lost their shirts.

So I know what happens to markets when easy money comes to town and people are ready to leverage up.  It’s called “reaching for yield.” And this is what is happening in European markets right now. The Guardian reports:

Investors are in turn flocking to the more risky high-yield market because of the low returns offered elsewhere with interest rates at historic lows. They are attracted to returns of about 7 or 8%, compared with the 3% they get from a more regular loan.

However, Standard & Poor’s, another ratings agency, warned that the rush back into junk products could be dangerous. "Are memories in the capital markets getting shorter? The global markets have just experienced one of the worst liquidity and credit dislocations since the Great Depression … We believe that investors might want to consider the benefits of maintaining discipline in structuring, pricing, and distributing high-yield bond transactions," the company said.

A high-yield conference in London last week saw about 200 bankers, investors and corporate treasurers gather to cheer the return of a market that still represents a small fraction of the funds raised by European companies.

Traditionally, businesses in Europe have relied more on bank loans built on longstanding relationships and local contacts. But banks are still shoring up their books in the wake of the credit crunch and have turned down some of their traditional clients. Slowly, the European high-yield market is turning more towards a US model, more reliant on institutional investors, such as pension or hedge funds. The US, with an economy similar to Europe’s, has a junk bond market which is about four times bigger.

Now, to be fair, the last comment about the European High Yield market is on the money.  There is huge potential for Mittelstand companies in Germany, for example, whose loans are saddling bank balance sheets to use the high yield market as an alternative source of capital. I certainly expect Europe to be a key area for the expansion of the global high yield market. 

Nevertheless, from the investing side, risks are now being taken that have as much to do with artificially low yields as with the attractiveness of high yield bonds.  I can’t help but think I have seen this movie before and it does not have a happy end.

Related posts:

• Fridson Says Junk Debt Is ‘Extraordinary Opportunity’
• Gross isn’t buying corporates, high yield or equities even with zero rates
• Corporate defaults mean more hedge fund blow-ups
• Bloomberg talks Eastern Europe as Latvia downgraded
• Market risk is high

Elga Bartsch writes that Morgan Stanley looks at the recent data coming out of Eurloand as distinctly bullish. As a result, they are revising up their GDP estimates.

A number of countries, notably the euro area’s two largest economies – Germany and France – posted a surprise rise in 2Q GDP. Others – like Italy, Spain and the Benelux countries – still saw a marked decline in activity in April-June. For the euro area as a whole, at a non-annualised -0.1%Q, 2Q GDP also came in ahead of expectations. Hence, the economy is stabilising after having been in free-fall over the winter. A number of special factors have flattered 2Q GDP, notably consumer spending that was boosted by car-scrapping schemes and construction activity that recovered after an unusually cold winter and benefited from government sponsored infrastructure spending. The outlook for the current quarter remains benign and there is potentially scope for near-term upside surprises. But at the same time there is little in the 2Q GDP reports and the current macro economic environment that would cause us to revise the euro area outlook significantly.

Incorporating the 2Q GDP releases and, in some cases, revisions to past data, into our full-year estimates causes us to raise our forecasts slightly. The full-year contraction in euro area GDP this year now stands at -4%, a relatively small revision compared with the previous estimate of -4.4%. The small upgrade to the euro area estimates masks larger upgrades for Germany and France and downgrades for Italy, Belgium and the Netherlands. Our Spanish forecast stays broadly unchanged for 2009. As we left the outlook for 2H09 virtually unchanged, our 2010 full-year estimate only changes marginally from 0.5% to 0.6%. These forecast changes do not constitute a material change in view. In fact, we reiterate our long-standing call for a tepid, below-trend recovery in the euro area. We acknowledge the risk that this profile might turn out to be more bumpy than the one we currently envisage.

Bartsch goes on to write that several factors will impede a revival in Euroland growth, mainly weak consumer spending underneath the stimulus of the car scrappage schemes, which are merely pulling forward demand.  Low income growth due to high levels of unemployment are a large factor here.  Moreover, business investment may be weak as well.

One bullish factor for Europe is the inventory destocking in Q2 is likely to turn the other way in Q3 and beyond just as it is likely to do in the US.  This means that Q3 numbers in Euroland will be flattered by a net contribution from the inventory cycle (less inventory purging or outright restocking).

On the whole, it is striking that so much bullish data is coming out of Europe when it seemed that the US was poised to exit recession sooner.  I admit to also having seen Europe as a laggard. But the German PMI data and French manufacturing data released today reveal a broader rebound, not just in manufacturing but also in services, where the recovery in the US has been weak.

Related posts:

• More thoughts on quantitative easing from Morgan Stanley
• Morgan Stanley: Recession will ‘end by mid-to-late summer’
• When will the U.S. recover?
• Morgan Stanley’s V-shaped recovery is my W-shaped double dip
• Are European banks sitting on 16.3 trillion in toxic assets?

From the FT.

Iceland’s bid to join the European Union received a boost on Monday when the 27-nation bloc’s foreign ministers agreed without delay to ask the European Commission for its opinion.

The swift decision means that Iceland, which only submitted its membership application on July 17, has already moved ahead of Balkan countries such as Bosnia-Herzegovina and Serbia in the queue at the EU’s entry door.

The speed at which the EU is likely to process the application reflects the fact that Iceland, as a member of the European Economic Area trading system, already participates in the European single market and applies about two-thirds of all EU laws.

Moreover, Iceland belongs to the EU’s Schengen agreement, which permits passport-free travel across the borders of 25 European countries.

At present there are only three official candidates for EU membership – Croatia, the former Yugoslav republic of Macedonia and Turkey – and each faces formidable obstacles on the road to entry.

Iceland is the kind of member the EU wants.  No wonder they are on the fast track.  But, this is sure to annoy the Baltics, the Turks, and the Balkan countries waiting on the outside.  The FT sees 2011 or 2012 as the earliest Iceland can join.

Related posts:

• The EU promises to bail out eurozone members
• Is Ireland the next Iceland?
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”
• Iceland and the wonders of competitive currency devaluation
• Denmark wants in on the Euro

Why is it that Jon Stewart, a comedian, has become the most able and trusted voice of investigative journalism into finance on television?  He spoke with the French Finance Minister Christine Lagarde, something I find remarkable given America’s disinterest in anything foreign and the enmity for the French amongst the xenophobic camp.

Christine Lagarde is a well regarded figure in finance who is largely unknown in the U.S. She is also one of the leading figures pushing for international regulatory reform, which I have said is necessary if we are to make any strides in safeguarding our financial system. I did a search for her in all of my RSS feeds and the last US. reference I came up with was this video from the Charlie Rose show back in April.  But, here she is on The Daily Show.  Go figure.

Related posts:

• French economy contracted in Q2
• Europe is in for a rude awakening
• Forstmann on Charlie Rose: easy money caused crisis
• A conversation with Peter Orszag on Charlie Rose
• IMF Head Dominique Strauss-Kahn on Charlie Rose

The Economist released its remarkably telling Big Mac Index this past weekend.  The index looks at the relative cost of Big Mac in various countries to gauge how over- or undervalued the currencies in those locales are.  Judging from this Index, there are some monster distortions in the currency markets right now.

The numbers marked in red are the areas I would like to highlight. They are representative of massive currency overvaluation in Europe (+72% in Norway, +55% in Denmark, +29% in the Eurozone) and absurd levels of undervaluation in Asia (-49% in China, –52% in Hong Kong, –47% in Malaysia and –42% in the Philippines).  One might argue the European overvaluation represents a repudiation of the U.S. dollar.  Sterling is only +3% versus the Dollar in the index, so that suggests a repudiation of the Pound as well.

On the other hand, Asian currencies are generally not floating but rather fixed via dirty float to the U.S. dollar. For example, the Malaysian ringgit and the Chinese renminbi are two currencies with a managed float. So, the undervaluation of Asian currencies is a political decision of mercantilist economic policy in the region. This has been a major cause of the fabled Asian savings glut and large current account surpluses in Asia.  In my view, this as also been a major source of instability in the global financial system. 

Clearly, Bretton Woods II has outlived its usefulness.

Source

The Big Mac index: Cheesed off – The Economist

Related posts:

• The Big Mac Index
• The dollar is rising against floating currencies
• Is the Fed just jawboning?
• The weak dollar trade regains momentum
• U.S. Dollar: Cliff Diving Again

Central banks are not the only ones printing money to help get through this financial crisis.  Private citizens are increasingly turning to the printing press to help alleviate their financial problems as well.  My translation of an article from Finanzas, a major Spanish finance website, explains.

A total of 413,000 counterfeit euro banknotes were withdrawn from circulation in the first half of 2009, representing an increase of about 17% compared to the amount recovered in the previous six months, as reported today by the European Central Bank (ECB ) in a statement.

The 20 euro banknote was the most counterfeited in the first half of 2009 and accounted for 48.5% of all counterfeits detected, followed by 50 euros (34%) and the 100 (13.5%).

Fewer counterfeit banknotes were of 5 to 500 euros (0.5%), the ten-euro (1%) and 200 euros (2%). The sum of these three  intermediate bills (20, 50 and 100 euros ) represented over 95% of all counterfeits.

The majority (over 98%) of counterfeit notes withdrawn in the first half of 2009 was detected in countries in the euro area, only about 1% in EU Member States outside the euro area, and  less than 0.5% elsewhere in the world.

he ECB explained that during the period under review there was no significant new classes of forgery, so the increase is due solely to a wider distribution of the types of forgeries. The level of counterfeiting should be compared with the number of genuine euro banknotes in circulation (a total of 12.5 billion during the first half of 2009).

However, the ECB recommends that the public to be vigilant with regard to the notes they receive in cash, because the more you’re familiar with the properties and features of genuine banknotes, the easier it will detect a counterfeit.

What this article does not address is who is counterfeiting and where. Back in May, I highlighted an article in the Economist which notes that counterfeiting is endemic in countries like Peru.  Certainly, almost half of the larger denomination coins I received when I was there were counterfeit.  I quickly learned to scrutinize these coins and reject fakes after counterfeits I was passed were rejected on several occasions.

But, in the EU, there i a counterfeiting problem now as well. In fact, there has been a movement afoot to reject notes issued in countries like Portugal, Italy, Spain, and Greece. If you try to pass a Portuguese note in Germany, you might find it gets rejected as many Germans do not trust those bills. While I look at the comments of Ambrose Evans-Pritchard about Europe digging its economic grave as hyperbole from someone who is a known Euro-sceptic, the counterfeiting problem is undermining trust in the Euro.  At a minimum, this does highlight the fact that the U.S. dollar is not destined for the reserve currency dustbin just yet, despite the obvious flaws of the global financial system.

Related posts:

• The dow in euros
• Is the ECB all-in on printing money?
• Why are the Swiss now issuing debt in U.S. Dollars?
• EU planning 200 billion euro package for Eastern Europe
• Don’t underestimate the power of printing money, part 2

I happened upon an article about shops being closed in France that highlighted a larger issue about cultural attitudes in the U.S. and Europe regarding work, leisure and material wealth.  I would like to share some thoughts with you on these issues because I think they are significant in regards to savings, debt and other issues at the heart of the recent economic bubble and meltdown.

Shops closed? How 19th century.

First, the blurb on French shops posted by Jay Newton-Small on Time Magazine’s political blog Swampland.

Michelle Obama has unwittingly caused a national French debate over working on Sundays. It seems the First Lady wanted to take Sasha and Malia shopping while there: the problem was virtually every store in Paris is closed on Sundays. There is a ban in France, a Catholic country, on working the day God rested. Embarrassed, Prime Minister Nicolas Sarkozy personally called a few stores and asked them to open especially for the Obama ladies. Sarkozy has since introduced a law, expected to be voted on in the National Assembly on July 6, to allow shops in touristy areas to remain open on Sundays. In an article entitled, "If You Have to Work Sundays, It’s Michelle Obama’s Fault," Sarkozy, roughly translated, argues: "Is it normal that when Mrs. Obama wants to visit French stores with her daughters on a Sunday, I have to make a call to have them opened? Everyone in President Obama’s entourage was present, great. Who then had to explain to them why we are the only country where, even in Paris, everything is closed on Sunday?" A spokesman for the Communist Party responded saying Sarkozy "crossed the line" by invoking Michelle Obama. Vivre le shopping!

In America, shops are open every day, often well into the night when most people are at home with their families.  This is especially true in America’s big cities, especially in the northeast and west.  Clearly, Michelle Obama has been living that lifestyle and was unconscious of how different it can be in Europe or even in other parts of the U.S.  It is admirable that the First Lady spends so much time with her children. However, in this case, every hour extra she gets to go shopping with her daughter is one hour less that the people working in those shops have with their own children.

So, why the cultural divide here?  Religion is certainly part of it in the Midwestern and Southern America and in France – hence the allusion to France’s being a Catholic country.  But, Germans also frown upon opening shops on Sunday as well and they are not all Catholics, though many are.  I would say much of the difference has to do with culture.

Europe equals leisure while America equals wealth

A few years ago, three economists (including a brilliant former classmate of mine, Bruce Sacerdote) produced a paper called “Work and Leisure in the U.S. and Europe: Why so Different?” Below is the abstract. (emphasis added)

Americans average 25.1 working hours per person in working age per week, but the Germans average 18.6 hours. The average American works 46.2 weeks per year, while the French average 40 weeks per year. Why do western Europeans work so much less than Americans? Recent work argues that these differences result from higher European tax rates, but the vast empirical labor supply literature suggests that tax rates can explain only a small amount of the differences in hours between the U.S. and Europe. Another popular view is that these differences are explained by long-standing European "culture", but Europeans worked more than Americans as late as the 1960s. In this paper, we argue that European labor market regulations, advocated by unions in declining European industries who argued "work less, work all" explain the bulk of the difference between the U.S. and Europe. These policies do not seem to have increased employment, but they may have had a more society-wide influence on leisure patterns because of a social multiplier where the returns to leisure increase as more people are taking longer vacations.

Translation: Europeans worked more than Americans just four decades ago, but now work less. Thus, they are taking more of the benefits of increased wealth since that time in the form of leisure over material gain than do Americans.  In a nutshell, Americans are more materialistic than Europeans.

Now, you can argue why Americans work more.  The economists make the case for unions as the driving force behind this dichotomy.  That’s an argument for another day.  My focus here is on the fact that cultural differences have developed such that Americans prefer to work many more hours in order to accumulate wealth than do Europeans.

For example, productivity levels in the United States and Western Europe are not that far apart.  The 2008 OECD Factbook as the following quote:

In 2006, GDP per capita in OECD countries ranged from over USD 39 000 in Ireland, Luxembourg, Norway and the United States to less than USD 17 000 in Mexico, Poland and Turkey. On average, income levels were about 70% of that of the United States, Norway is a notable exception with its GDP per capita 14% above that of the United States.

Relative to the United States, most OECD countries had higher levels of GDP per hour worked than GDP per capita because their levels of labour utilisation were substantially lower than in the United States. This owes to disparities in working hours but also, in several countries, to high unemployment and low participation of the working-age population in the labour market.

Europe is just as productive as the U.S. But, clearly Europeans are choosing to work less than Americans.  Think store closings on Sunday in Paris.

The asset-based economic model

The result of America’s drive to work more has been an asset-based economy driven by debt. In America, and similarly in other Anglo-Saxon countries like the U.K., debt and savings are viewed in many parts quite differently than they are in places like Germany.  In the Anglo-Saxon model, people talk about things like efficient markets and wealth accumulation with almost religious fervour. Work is certainly prized as means of accumulating wealth. But, so too are debt and asset accumulation.

That leads to a greater reliance on markets and debt.  Look at any measures of aggregate national debt to GDP and you will see the U.S. and the U.K. at enormous levels over 300%.  The same is true in terms of market capitalisation levels.  The U.S. and the U.K. are much higher in terms of publicly listed companies as a percentage of GDP than, say, Germany.

German politicians disparage this as the Anglo-Saxon economic model – and since it is an election year in Germany, we are bound to hear more of this than usual. I call this the asset-based economic model.  The goal is to accumulate as much wealth as one possibly can by buying as many assets as one can, through income (hard work) and debt (mortgaging future income).

I find all of this a bit like a rat in his cage chasing a hunk of cheese.  After all, there are only so many hours in the week to divide between family, leisure, work and sleep.  And, there is only so much you can borrow against future income. At some point, lenders figure out they have lent more than you can possibly earn and pay back.

And that’s the message here and now, isn’t it? We have seen a massive credit bubble which has taken debt levels to unimaginable proportions – all in the quest for more material wealth.  My guess is that the pendulum, having swung too far in the one direction, is headed back the other way.  While risky debt-financed binges seemed the road to riches in the asset based economy, the conservative new normal will be savings.

My hope is that this new normal not only ushers in a world where high debt and low savings are frowned upon.  I also hope we see a re-allocation of time and energy away from work and wealth accumulation and toward other more important things like family and leisure.

Related posts:

• Barack Obama ushers in a new era in America
• The U.S. is exporting unemployment with ‘Buy America’
• Remittances to Eastern Europe to slow dramatically
• Twenty wealthiest towns in America
• Europe is in for a rude awakening

For the time being, I am more worried abut the potential inflationary effects of quantitative easing than about the deflationary impact of deleveraging.  But, the latest news from Ireland shows us that deflation is alive and well. This comes via the Irish Independent:

Consumer prices recorded a second annual drop in April as the cost of energy, clothes and food declined amid a deepening recession.

Prices based on a European Union measure dropped 0.7 percent from a year earlier after falling at the same rate in March, the Cork-based Central Statistics Office said today. The decline in March was the first annual drop since the data were first collected in 1996. Prices rose 0.1 percent in April from the previous month.

Crude oil has dropped around 60 percent since reaching a record $150 a barrel in July. At the same time, waning consumer demand as unemployment rises has prompted stores to cut prices.Tesco this month said it will reduce prices at some Irish stores by as much as 22 percent.

Rising unemployment and tax increases have “heightened consumers’ reluctance to spend,” Lynsey Clemenger, an economist at Ulster Bank in Dublin, said in an e-mailed note today. “Prices have further to fall, as the consumer strike continues.”

The EU measure excludes mortgage interest payments. Based on an Irish gauge, prices fell 3.5 percent in April from a year earlier, the biggest decline since 1933.

In my opinion, the ECB’s recent announcement that it was getting into the covered bond market has a lot more to do with Spain and Ireland than it does with Germany.  Spain and Ireland suffer from their joining the Euro to escape the impossible trinity of free exchange rates, independent monetary policy and free capital movement.  Having sacrificed monetary policy for a fixed exchange rate, the Spanish and Irish are seeing some horrific debt deflation dynamics.  The ECB seems to have awoken to this and is now engaged in quantitative easing via the covered bond market (although Trichet denies this). See Edward Hugh’s take on this from a Spanish perspective.

So, Ireland has joined the deflation camp along with Spain, the U.K., Switzerland and China, to name a few.  If you think this deleveraging cycle is too powerful for the money printers to override, you’ll see the increasing number of countries with deflationary numbers as a bad harbinger.  However, if like me, you are equally concerned about the upturn in commodity prices and the steepness of the yield curve, you will also see inflation as a looming threat.

To be continued.

Related posts:

• Germany gets deflation
• Irish unemployment gaps up by most in 40 years
• Spain gets deflation
• Switzerland gets deflation too
• U.S. CPI: Lowest since 1954 – deflation here we come

This morning you may have read Gideon Rachman’s positive view on Hungary.  He said the panic is all but over and it looks like Hungry is going to get through this debt crisis.

The horror scenario envisaged a Hungarian banking collapse that would ripple back into the rest of Europe and then around the world. Many EU banks have lent heavily in central Europe. Austrian banks are thought to have lent the equivalent of more than 70 per cent of their country’s gross domestic product to the region. This idea – perhaps combined with a folk memory that the Great Depression had something to do with the collapse of an Austrian bank – helped heighten the panic about Hungary.

But, having just visited Budapest, I can return with good news. The immediate crisis is over. There was a moment when there was a real fear of a bank run. One Hungarian financier is quite precise about the date: Friday, March 13. However, confidence just about held up, the moment passed and so has the threat of imminent collapse.

The unfolding of the Hungarian crisis now looks like a microcosm of the world crisis. Fear of financial collapse is gradually giving way to worries about an unprecedented contraction in the economy – with all the social and political consequences that could imply.

The Hungarian government has predicted that the country’s economy will shrink by 6 per cent this year. It has not performed that badly since 1945. Unemployment is rising and so is inflation, because of the fall in the Hungarian currency.

Hungary has no room for the kind of counter-cyclical Keynesianism that is being tried in the US and the UK. Nobody thinks the markets would tolerate huge fiscal deficits, so instead the government is cutting spending and raising taxes. State pensions were sliced by about 8 per cent last week. Sales tax has just been increased. And this is just the start of an austerity drive.

So, to recap what Rachman is saying, Hungary is looking pretty awful, but it could be worse. But, is that really true?  I’ll come at this question via Latvia and the troubles now ongoing there.  Yesterday, we learned that Latvia’s economy shrank 18% in the period from Q1 last year to Q1 2009.  This is a Great Depression scenario for Latvia.  But, the other Baltics, Estonia and Lithuania, are imploding as well.  For example, at the end of April, Lithuania reported a 12.6% drop in year-on-year GDP – not as bad as Latvia, but a Depression with a Capital ‘D” nonetheless.  I had asked in July if the Baltics were the next Argentina.  The answer is obviously, yes.

So what does this have to do with Hungary?  A lot. Western banks piled into the former Soviet bloc in Eastern Europe during this decade’s boom.  And with growth coming off the boil those bets are coming a cropper.  Certainly, things look much worse in Latvia than they do in Hungary.  Hence, the optimism from Rachman.  But, the guys at Brown Brothers Harriman are not onboard with the all clear call.  They have a bearish view on Eastern Europe. Here’s what they had to say regarding sovereign credits today:

Moody’s has been busy today, downgrading Ukraine to B2 from B1 and Kazakhstan to Baa1 from A2.  Interestingly, Moody’s damned Mexico with faint praise yesterday by saying that it couldn’t see Mexico losing its investment grade rating.  Of course, that doesn’t rule out downgrades from the current Baa1 rating, and we note S&P just put its BBB+ on negative outlook.  Our EM sovereign rating model puts Mexico at BBB-/Baa3, and so the case is strong for a downgrade.  However, Moody’s appears to be correct about Mexico hanging on to its investment grade rating.  Our model puts Kazakhstan at BB+/Ba1, and so significant downgrades are warranted.  Again, we are incredulous that Moody’s put it at A2 in the first place.  We also put Ukraine at B-/B3, and so another downgrade there is warranted.  Given how poor 2009 is shaping up to be in terms of growth, capital flows, etc., we believe the rating agencies will continue to downgrade the weaker EM credits into 2010.  And it’s not just EM that the agencies are going after, with Fitch today moving Greece’s outlook to negative from stable (Greece was already downgraded by S&P in 2009, with agencies cutting Ireland, Portugal, and Spain this year too).  We reprint below our ratings outlook that was in the latest quarterly, since these views still hold:

The Baltics:  Despite seeing some downgrades already, Estonia, Latvia, and Lithuania remain highly overrated.  All still face serious crisis risks in 2009, and it’s likely that the other two will eventually follow Latvia into an IMF program.  None of them deserves an investment grade rating, and we look for multiple downgrades in 2009.  Note that IMF programs did not prevent downgrades during the Asian crisis.

EMEA:  Most of the other countries in this group are facing significant downgrade risk this year too, though perhaps the Czech Republic slightly less so.  Hungary’s rating is the most out of line and faces the most downgrade risk in 2009, followed by Iceland, Bulgaria and Romania.  We believe Poland and South Africa face moderate downgrade risk.

You should notice that Hungary is an outlier in their analysis with significant downgrade risk.  So, it is not a case of all clear at all, not for the Baltics and not for Hungary either.  Edward Hugh at “A Fistful of Euros” have been chronicling these events. Read his posts on these events over the last two days:

• The Agony Continues – Latvian GDP Falls By 18%
• “Not All East The European Economies Are The Same”
• Non-performing Loans In Latvia

So, while the outlook is much improved, the risks are far from over.  With regard to the crisis in Eastern Europe, most people had been focused on Austrian banks and Central Europe (Hungary, Poland, Slovakia, Czech Republic).  I have written on this on a few occasions as well, even throwing in a vague reference to the Great Depression a post called, “1931.”  But, the Scandinavian banks’ exposure to the Baltics is just as worrying and should be the place to watch before we give a definitive all-clear.

Related posts:

• Hungary cut to a notch above junk by S&P
• Baltics: Fitch downgrade and more downgrades to come
• More trouble in the Baltics as S&P downgrades
• Roubini’s RGE Monitor: Threat of ‘Asia-Style Crisis’ in Eastern Europe
• Moody’s: Iceland, Latvia and Hungary in “fragile stabilization”

The following is a worthy analysis from Marc Chandler of Brown Brothers Harriman regarding the recent GDP numbers released in the U.S. and their significance for currencies (emphasis mine):

The initial reading of the US Q1 GDP was worse than expected, though the dramatic fall in inventories and the tax cuts that went into effect April 1 still suggest that better days are ahead. In Europe, the ECB’s Weber played down the improvement in sentiment indicators. He warned of a significant European contraction this year. Earlier the Econ Minister had forecast a 6% contraction in Germany this year. Weber warned that although he pace of contraction may ease, a recovery in 2010 at the earliest is dependent on resolving the toxic asset problem, for which there is much uncertainty, despite of course the different regulatory regime. ECB President Trichet argues that the dealing with the toxic assets is a fiscal issue not a monetary issue. In contrast, the US does not appear to be drawing such a fine distinction. But Trichet’s statement, it does not mean that the ECB has not opinion. Weber urges German politicians to resist demands for additional fiscal stimulus.

The euro, which had dipped below $1.30 yesterday, has again advanced to challenge the upper end of its recent range near $1.33. A break of $1.33 could see a quick run toward the down trend line drawn off the late March and early April highs and comes in near $1.3375 today. That said, there is talk of good demand for $1.3500 and higher calls for short-dated (1-2 week) euro calls. The 5 day moving average is likely to cross above the 20 day average, which we find to be a useful trend indicator. Technical indicators, such as momentum readings do not stand in the way of another leg up in the euro. Of course, next week brings the ECB meeting, where additional measures, or really modifications of existing programs, are expected. The day after the ECB meeting, the US reports employment figures and another 600k+ jobs are expected to have been lost.

Related posts:

• EU: Banks ask for a bailout for poor lending in Eastern Europe
• Big Mac Index: Europe overvalued, Asia undervalued
• UBS does not see the need for panic over Eastern Europe
• U.S. Dollar: Cliff Diving
• Europe on the ropes

The following is the currency outlook released today by the Brown Brothers Harriman Currency Strategy team:

Swine flu and concerns about US banks may be hitting the headlines but, the European banking sector remains a threat for the euro zone. Indeed, ECB President Trichet, speaking in NY yesterday, highlighted the fact that the European banking sector is significantly important in the euro area compared to the US although Trichet noted signs that liquidity was moving away from the ECB balance sheet to the money markets was an indication of improving confidence. The President held back from making any strong hints about policy, merely stating that any non-standard measures would be announced at the next meeting May 7. He attempted to address the criticism that the ECB’s refi rate is higher than the Fed rate by pointing out the importance of the 0.25% deposit rate in Europe, and the rough parity of euro and dollar money market rates. The President also defended the ECB’s stance on policy indicating the ECB had been the first to introduce non-traditional policy measures. The ECB’s balance sheet did expand in late 2008 although overall assets have slipped by more than 10% since their January highs. While the Fed’s balance sheet also slipped as some programs such as the commercial paper program began to take affect, the Federal Reserve have continued to adopt additional policy measures including the purchase of US Treasuries and expanded its MBS program to address other financial concerns. The ECB President and some ECB members including Weber and Hurley appear to be continuing with a cautious approach to policy. That’s in contrast to other ECB members such as Austrian Council member Ewald Nowotny whose dovish comments yesterday coincided with the euro’s tumble by over a big figure to around $1.30 yesterday. Nowotny said the central bank ‘stands ready to use unconventional measures of quantitative easing to assure European firms and consumers access to credit at appropriate conditions.’

The Japanese yen is the top performer against the major currencies today; the US dollar has now given up 38.2% of this year’s gains against the yen (JPY95.98) while the euro cross has now lost half its gains (124.76). That isn’t a reflection of the Japanese economy. While there have been some signs that the decline in exports may be easing, today’s retail sales point to ongoing weakness in the consumer sector. Retail sales fell for a seventh month in March. Sales were down 3.9% from a year ago compared with February’s 5.7% slump. Though better than the 4.7% drop expected, this is still a sharp decline, and just one month’s data. Meanwhile, the April business confidence index showed a slightly better monthly outcome, up to 30.8 from 30.4, though not as much as expected. Note that the BoJ is holding its regular meeting on Thursday: rates will most likely stay on hold (at 0.1%) and the central bank already on a program of quantitative easing.

The Mexican peso has lost further ground overnight amidst concern about the escalation of the swine flu scare. The World Health Organization said the flu outbreak is no longer containable, upgrading its global pandemic alert level to four from three. The current outbreak of flu in Mexico is a cause for concern for both the people of Mexico and the economy, but is also raising concerns about the possible effects on economies worldwide. Level five signals a pandemic is imminent while level six signals it is under way. However, it remains too early to make any material changes to our Mexico forecasts just yet, but the situation bears close watching. There was further news that could increase risk concerns for investors with the Wall Street Journal reporting that US regulators have told Bank of America and Citigroup that they need to raise more capital based on the stress tests. The two banks are expected to respond, denying the assessment, according to the report.

Related posts:

• U.S. Dollar: Cliff Diving Again
• The dollar is rising against floating currencies
• U.S. Dollar: Cliff Diving
• Japanese defend dollar’s status while China tears it down
• Chart of the day: Japanese Yen

I want to make clear the significance of the Treasury’s Chapter 11 bankruptcy plan for Chrysler if Fiat pulls out.  It will mean massive job losses and and a huge down-tick in consumer demand.  There will be no second half recovery. Geithner and Obama will look very much like greenhorns and lose a lot of credibility.

This is a very real possibility given the statements coming out of the German press.  While the U.S. Government is integrally involved in both the Opel-Fiat-GM and the Fiat-Chrysler love fests, it remains to be seen that they can strike a deal that is agreeable to all parties. These are very, very complicated negotiations, involving legal and employee issues in three different countries.

Handelsblatt, the most widely-read Finance paper in Germany said the following earlier today:

In searching for an investor to survive, first serious interested parties for struggling carmaker Opel have crystallized. Fiat Group and the Austrian-Canadian auto supplier Magna are the hot contenders for the Rüsselsheimer company. “Fiat and Magna are possible partners. But it should also be clear that there no decisions have been made,” said the Hessian Minister President Roland Koch (CDU). The Rhineland-Palatinate’s Minister for Economic Affairs Hendrik Hering (SPD) also confirmed that Fiat and Magna count as the main contenders for Opel.

An entry of Fiat would be problematic because of its high debt and the excess capacity of the Italians, Herring said through his spokesman Joachim Winkler. Opel employs about 3,400 workers in an engine and transmission factory in Rhineland-Palatinate.

As early as next week, we probably should have a memorandum of understanding between Fiat and Opel signed. Fiat and the management of Opel declined to comment. Opel works council chief Klaus Franz, however, confirmed that Fiat seek a majority takeover. In negotiating circles it is said that Fiat has already been talking with the Federal Government in the past week.

For the struggling General Motors subsidiary, a long-awaited new investor is in its grasp. But the looming entry of Fiat, ensures trouble, even before completion of negotiations: the employees’ side, announced opposition to the Italians. They feared massive job cuts if the majority Fiat took over. Works chief Franz yesterday intentionally brought the talks with Fiat into the public in order to torpedo the unwanted merger.

Amongst deal makers, it is said that GM management in Detroit and the federal government favor a quick solution with the Italians. Fiat managers met yesterday together with Jochen Homann, State Secretary for the Federal Ministry of Economic Affairs, in Washington to deal with the U.S. side over the Italians start at negotiations. The federal government has, in the case of an entry at Opel, made guarantees and is therefore very much involved in the search for investors. Even representatives of the Hessian state government are already in Washington. Opel’s headquarters are in Hesse.

Opel has already scheduled a Tuesday press conference. GM boss Fritz Henderson had said last Friday that the U.S. company is talking with more than six interested parties, for whom it has opened the books. Opel wants to largely decouple from GM and is looking for investors for an independent company in which GM has only a minority participation.

With a merger of Opel and Fiat, two companies would be back together, which split in dispute n 2005. At the time, GM paid 1.55 billion euros, in order not to have to take over the automotive business of Fiat. In 2000, GM and Fiat had started the joint development of engines and transmissions in Europe. At the same time, the U.S. group bought ten percent of Fiat’s shares. Again, this has been reversed. Opel and Fiat are direct competitors in many markets. Works chief Franz is, therefore, afraid of a “dramatic loss of jobs at Opel and plant closures in Germany.”

An Opel-Fiat merger will be resisted by the unions in Germany. But, just as with the Dresdner-Commerzbank merger, this can be overcome if there are no good alternatives.

GM has the best hand here as it is going to get rid of Opel come hell or high water. Fiat is next because they have a choice of Opel or Chrysler. Opel is next because it has multiple suitors lined up and the German government is probably willing to bail it out temporarily if a suitor can’t be immediately. Chrysler and the U.S. Government are in the worst situation because they need a deal desperately. Their best alternative to a negotiated agreement is bankruptcy.

Source
Fiat und Magna buhlen um Opel – Handelsblatt
Fiat in talks to buy Opel and Vauxhall – Guardian

Related posts:

• Opel and Fiat spells bankruptcy for Chrysler and GM
• Fiat as the engine for change in the auto industry
• Chrysler: bulls make money, bears make money, pigs get slaughtered
• Germans reject Chinese offer for Opel
• GM headed for bankruptcy

We should consider Spain one of the four original bubble markets where residential property markets soared to ridiculous levels during the housing bubble.  The bubble has now popped and those countries, the U.K., the U.S., Ireland and Spain, are reeling.  To be sure, there were bubbles in other markets as well. However, these four markets should certainly be the big economy markets to watch.

You may have seen the recent report on the Spanish savings bank Caja Castilla-La Mancha where the government was forced to intervene.  This is the tip of the iceberg when it comes to the savings banks.

Back in August, you may recall that Dutch Central Bank head Nout Wellink, who is also an ECB governing council member, said the ECB has to stop propping up banks.  Most people in European finance knew he was pointing the finger at the Spanish cajas in particular as they were addicted to ECB credit.

Fast forward to today in the wake of the Caja astilla-La Mancha episode and reports are emerging of huge potential losses in Spain:

The cajas, which are mutual banks controlled by regional politicians, have a bigger problem with bad debts in Spain than shareholder-owned counterparts such as Santander and BBVA.

The cajas were more aggressive during the good times – loans to developers increased by more than 50pc in 2006, and account for a fifth of their total loan books. This explains why the ratio of non-performing loans stands at 4.5pc for the cajas, against 3.2pc for commercial banks.

It looks like the Bank of Spain, which kept Spanish banks from buying toxic assets out of the US, wasn’t prudent enough at home. True, banks were ordered to build a thick cushion of generic provisions during the good years. But for some cajas, these provisions will be eaten up by losses. In the last year, the sector’s ratio of provisions to bad debts, or coverage ratio, has fallen from about 200pc to just 56pc.

As property prices fall and new developments sit unsold, the cajas’ losses mount. Credit Suisse estimates the cajas will need to raise €60bn just to keep the ratio of equity to non-performing loans at 160pc.

That may be high. Suppose 10pc of whole loan book – and a quarter of the €172bn of loans to developers – go bad. And suppose only 40pc of their value of the loans is recovered. The total losses would be about €34bn – eliminating nearly half of the current equity in the sector.

Savings banks could cover part of the hole with operating profits and existing provisions. But they have only €23bn in provisions now. To get the buffer up to 75pc of non-performing loans, another €16bn needs to be found.

Some of the missing capital – losses and reserves – will be generated by operating profits, running at €15.2bn annually. Add it all up, and there still seems to be a capital hole of nearly €40bn. The gap isn’t spread evenly, and the richer cajas aren’t likely to want to share much with their poorer brethren via mergers. The Boss of Spain’s biggest savings bank, La Caixa, recently said mergers made more sense when financial margins were wider. So in practice, the shortfall is likely to be larger.

Some cajas can sell industrial stakes. But they can’t raise equity from private shareholders, as Santander recently did, because they are not listed. It looks like the government may have to foot most of the bill.

As I have said many times, the banks in Europe are well under-capitalized. Spain is not the only one here and this is going to become ever more apparent as 2009 takes its course.

Source
Spain’s savings banks could face €40bn hole in capital – Telegraph

Related posts:

• Spain: savings banks suffer while BBVA and Santander expand
• Spain intervenes to save Caja Castilla La Mancha
• Hypo Real Estate need for 10 billion also reveals huge problems in Spain
• Spanish unemployment up
• Consumer credit down a massive 33% in Spain

Two weeks ago, the Fed roiled bond markets by signalling it would start to purchase Treasury bonds with printed money – the very definition of inflation.  

Now, its the ECB’s turn to show it can inflate with the best of them.  They have adopted extraordinary measures despite the view of many that they have not inflated. But, the ECB has certainly not been nearly as aggressive as the Fed. Are they all-in now too?

Marc Chandler from Brown Brothers Harriman gives his view.

After the March 18th decision by the Federal Reserve to increase its purchases of we argued that contrary to what many pundits were saying, the Fed was not “all in” and there were and continue to be a number of additional steps the Fed could take.

The focus this week is on the ECB meeting. What can it do ? We highlight a number of things in today’s North American daily, pull them together for convenience here. The first thing to note, however, is that through its unlimited supply of liquidity and liberal collateral rules, the ECB has already engaged in what ECB President Trichet calls “non-standard” operations. Second, the previous policy maker and market focus on the refi rate is not longer applicable. The 150 bp policy rate is not the key operational rate. The market rate is closer to 100 bp and the deposit rate, which is what the ECB pays on reserves, is at 50 bp. Moreover, there is not much difference between libor rates. Consider June 09 Euribor implies a yield of 1.3%, while June 09 Eurodollar implies a yield of 1.14%. Dec Euribor 09 implies a yield of 1.46%, while Dec 09 Eurodollar implies a yield of 1.29%.

There are a range of options that the ECB can still chose from:

1. Extend existing efforts
   • lengthen duration of unlimited liquidity provisions
   • reduce “haircuts”, allowing greater loans for same collateral
   • accept lower quality collateral
2. New Efforts
   • purchase commercial paper
   • purchase long term corporate bonds
   • purchase long-term sovereign bonds

Our contacts and public commentary makes it appear that a majority of the ECB may not yet be ready to initiate new efforts. Expanding existing programs seems to be the more likely scenario, coupled with a modest rate adjustment. The ECB may also narrow the gap between the refi rate and the deposit rate which is now 100 bp wide. The deposit rate acts as the floor for short-term rates. The ECB could cut this to zero, but that also seems unlikely at this juncture. A 50 bp cut in the refi rate, and 25 off the deposit rate coupled with some tweaking of its current liquidity provisions seems more likely.

The euro’s response is not immediately evident. As pressure on the ECB has increased in recent days, the euro has weakened. It is possible that a “sell the rumor, buy the fact” type of trading materialize, keeping the euro weak ahead of Thurs ECB meeting. The following day is the US jobs data and another dismal report is expected. However, the weak jobs data has not meant a stronger euro (only 2 of the past six months has the euro finished higher on non-farm payrolls release days).

A break of $1.2950-80 support area for the euro would have ominous signs and point to a retest on the year’s low set on March 4 near $1.2460.

Related posts:

• Don’t underestimate the power of printing money
• Quantitative easing: printing money like mad to ward off deflation
• Private citizens now printing money too
• Are European banks sitting on 16.3 trillion in toxic assets?
• U.S. Dollar: Cliff Diving

This weekend has seen two major European financial institutions forced into the hands of government and a third on the verge of major new asset writedowns and job cuts. The events highlight the fragility of European banking and the need for concrete solutions at the upcoming G-20 summit in London.

First, in the UK, you may have seen a link in our news feed yesterday to reports of the demise of Dunfermline Building Society in Prime Minister Gordon Brown’s constituency.

Savers in the Dunfermline Building Society, Scotland’s largest customer-owned mortgage lender, will have their deposits protected by the U.K. government as it seeks to broker a sale of the company in the coming days, Prime Minister Gordon Brown said.

“Savers will be protected,” Brown said today at a press conference in Vina del Mar, Chile, where he was on an official visit. “It is important to recognize that throughout this whole crisis anyone who has saved has been protected. Our determination has been to ensure people’s savings are even safe in years to come.”

The government is seeking to arrange a merger or takeover of Dunfermline, a U.K. Treasury official said today. Authorities are looking for a “long-term solution,” said the official, who can’t be identified in line with departmental policy.

The government’s rescue of Bradford & Bingley Plc, an English mortgage lender, may be an example for Dunfermline, Scottish Secretary Jim Murphy told British Broadcasting Corp. radio today. Bradford & Bingley was nationalized in September as the global financial crisis worsened. The bank’s branches and deposits were purchased by Banco Santander SA, and the U.K. Treasury took over 41 billion pounds of mortgage loans.

The U.K. government has looked at “every possible option”, but “no other option was possible,” Murphy said of Dunfermline.

In the current financial crisis, the British government already has bailed out Royal Bank of Scotland Group Plc and Lloyds Banking Group and nationalized mortgage lender Northern Rock.

Scotland’s First Minister Alex Salmond said in a statement he was “deeply disappointed that the Treasury now believe it isn’t possible to sustain the society as an independent institution.”

Dunfermline employs almost 500 people, half at its headquarters in Fife and half in its network of 34 branches, the BBC said.

The company, which is based next to Prime Minister Brown’s parliamentary district, has been hit by losses on commercial real-estate loans.

This past December, I indicated that the U.K. and Ireland would see major domestic residential mortgage-related downturns and this looks to be occurring.

Meanwhile, in Germany, Hypo Real Estate (HRE), the mortgage lender which threatened to take down the entire German banking system last year, is in the news again. The company is haemorrhaging losses, having reported another 5.5 billion euro loss. Recently, the Germans changed their nationalization laws with the express purpose of taking over HRE. This now seems imminent.

Hypo Real Estate Holding AG, the bailed out German commercial real-estate lender, said it posted a wider-than-expected loss of 5.46 billion euros ($7.3 billion) last year and that the government will take an 8.7 percent stake as a first step toward nationalization.

Hypo Real Estate had a pretax loss of 5.38 billion euros compared with a pretax profit of 862 million euros in 2007, it said in a statement today. Four analysts in a Bloomberg survey had expected a net loss of 4.5 billion euros.

Germany’s bank rescue fund, Soffin, will acquire 20 million shares valued at 60 million euros, the company said in a separate statement. The new stock must be issued at a “minimum prescribed” price of 3 euros a share.

Hypo Real Estate, which lost 93 percent of its market value over the last 12 months, has already been bailed out by the government and financial institutions with credit lines and debt guarantees totalling 102 billion euros. The lender, which almost went bankrupt after its Dublin-based Depfa Bank Plc unit failed to get short-term funding in September, said today it expects to remain in a “loss situation” for at least two years.

“It is a prerequisite for the intended recapitalization of Hypo Real Estate Group by Soffin that either Soffin or the German government gain full control over Hypo Real Estate Holding,” the Hypo Real statement said. “To this end, it is intended to make use of the options that will be provided by the German Financial Markets Stabilization Amendment Act, which is currently being discussed in the legislative process.”

Nationalization Law

Hypo Real fell 1.7 percent to 1.14 euros a share yesterday in German trading, valuing the company at 240.6 million euros.

J. Christopher Flowers and Richard S. Mully, who lead a group of investors that together owns 23.7 percent in Hypo Real Estate, said on yesterday they were leaving the lender’s supervisory board because of “possible measures to be taken by the German government against Hypo Real Estate shareholders.”

Germany’s upper house, the Bundesrat, will be asked to approve the Hypo Real Estate seizure legislation when it comes before them on April 3, following its passage by the lower house on March 20. The law also imposes a time limit, stipulating that any seizure has to be initiated by the end of June.

The lender’s nationalization would be the first of a German bank since the 1930s.

The third European institution in trouble is a familiar one, UBS, the Swiss giant. Reports are emerging that they are poised to take writedowns, this time on their CLO (Credit Linked Obligations) portfolio. The Swiss are in a bit of a pickle because UBS is too big to bail, but remains systemically weak.

Switzerland’s UBS is expected to announce more writedowns and job cuts in the coming days, Swiss newspaper Sonntag reported on Sunday.

Shares in UBS, the world’s largest wealth manager in terms of assets, fell 7 percent on Friday as rumors swirled of a profit warning and more writedowns in the first quarter. The bank, one of Europe’s hardest-hit in the crisis, has already written down more than $49 billion since mid-2007.

Sonntag said UBS would write down at least another $2 billion on illiquid assets, including asset categories so far not much in the spotlight such as Credit Linked Obligations (CLOs), the paper said citing people familiar with the matter.

The Swiss bank giant would also slash another 8,000 jobs, the newspaper said, including some private banking staff.

You should note that NONE of these troubles have much to do with Eastern Europe, revealing that Western European banking has problems all of its own. With the G-20 in London coming up, these revelations make it that much more imperative that the Europeans step up and help deliver a multilateral solution to this mess.

Billionaire investor Gorge Soros has said the G20 summit will be a “make or break” event for the world’s economy.

In a BBC interview, Mr Soros said the international financial system had collapsed because it was flawed and it had to be restructured.

Mr Soros say it may be the last chance to prevent a full-scale depression.
He said the G20 meeting had to come up with concrete solutions to help the developing world in particular, which had been been worst hit.

‘Depression’

Mr Soros warned that any attempt to pull economies out of recession had to be done co-operatively.

He said: “The G20 meeting is make or break because unless they do something for developing world there will be serious collapse in that part of the world.

Don’t hold your breath.

Sources
U.K. Government to Protect Dunfermline Customers – Bloomberg.com
Hypo Has EU5.46 Billion Loss; Germany Buys Stake – Bloomberg.com
Fresh writedowns, more job cuts seen at UBS: report – Reuters
G20 ‘make or break’, Soros says – BBC News

Related posts:

• Hypo Real Estate need for 10 billion also reveals huge problems in Spain
• The German $400 billion toxic asset time bomb
• Hypo Real Estate: 600 billion in off-balance sheet assets
• Germany: banking system collapse possible due to Hypo Real Estate
• Is this Austrian real estate company a canary in the coalmine?

The following post is up on Morgan Stanley’s website and highlights the degree to which money printing has become the policy tool of choice used by central bankers with which to fight this deflationary threat.  I have highlighted the whole paragraph on the inflationary risk of all of this.

Central banks that have adopted QE have used very different strategies, except for one which they have all shared – they have managed to surprise markets with almost every announcement. Since our last write-up (see “QE2”, The Global Monetary Analyst, March 4, 2009), monetary authorities in the UK, Switzerland and the US have delivered hefty surprises to the market by introducing larger-than-expected or significantly enhanced programmes. The Bank of England put £75 billion of the £150 billion tranche approved by the Treasury to use on March 5, most of it to be used to purchase gilts. The Swiss National Bank announced on March 12 that it would buy corporate bonds as well as foreign currency – specifically the euro. Finally, at its meeting on March 18, the FOMC delivered a hefty increase in its MBS purchase programmes (from US$500 billion to US$1.25 trillion) and introduced a US$300 billion programme to buy Treasury securities.

We are optimistic about the traction from QE… QE is not a panacea for economic ills, but we believe that it can work in conjunction with the many other programmes that are attacking the problem from various angles. These actions from major central banks are a continuation of their earlier aggressive easing of policy rates and their willingness to use any and all available means to pull economic growth up by its bootstraps. The size of these programmes to purchase assets outright as well as the demonstrated commitment of central banks to persevere with unconventional measures are integral parts of the policy package.

…but we also see higher risks now. The increase in the size of the active QE programme directly increases the potential policy traction in much the same sense that pushing policy rates lower increases the monetary stimulus. However, the size of these programmes also raises risks in two ways. First, it increases the potential size of losses that the central bank and its guarantor (the government) may have to bear. Second, unwinding such massive purchases of assets will act like a sizeable contractionary monetary policy shock. While the chances of QE making a significant impact on the economy have increased, so have the risks associated with managing and correctly unwinding these programmes…

QE in the G10. The G10 aggregate policy rate is already close to zero. It is therefore not surprising that QE is being either considered or implemented here, depending on the need for further policy action. The Swiss National Bank announced its active QE package (purchases of corporate bonds and FX) only on March 12, but it has been using passive QE since November 2008. Both Norway and Sweden have allowed their monetary base to grow since September and October 2008, respectively, in sync with increases of the monetary bases of the G4 central banks. The Bank of Canada, having cut its policy rate to 0.5%, seems to be readying itself to use “credit and quantitative easing”. Our strategists believe that QE could be in action there sooner than markets expect.

Perhaps the most crucial decision on the adoption of QE clearly lies with the ECB. The ECB, like the other major central banks, has instituted a passive QE regime since September 2008. Our ECB watcher, Elga Bartsch, believes that the ECB is unlikely to go down the path of active QE, but would be quite willing to extend the term on repo operations. These facilities were put in place at an early stage in the crisis, have worked well and have been copied by other central banks around the world. Also, the ECB may widen the pool of eligible collateral yet again by lowering further the required minimum rating for eligible assets. There is still room to cut rates, and our forecasts project the refi rate at 0.5% in 2Q09. However, given the downside risks to growth, the adoption of active QE can clearly not be ruled out. If the ECB does decide to purchase assets on an outright basis, it is likely to prefer corporate securities to government bonds in order to ease credit conditions (for more details, see QE or Not QE? by Laurence Mutkin, March 20, 2009).

Now, I am going to stop there because I want to introduce a few words by Ambrose Evans-Pritchard of the Telegraph regarding the ECB’s quantitative easing strategy. Do read the rest of Morgan Stanley’s research at the link in sources.

ECB is clearly alarmed by the outright contraction of credit. Loans to non-financial corporations fell in February (minus €4bn).

Yes, the M3 money supply is still up 5.9pc year-on-year, but that is backward-looking. M3 growth has collapsed. The credit crunch that was not supposed to exist in the eurozone is already well advanced.

The bank’s vice-president Lucas Papademos (ex-MIT, a heavy-weight) said: “It may be warranted that the central bank purchases private sector bonds to enhance liquidity. No decision has been taken, but it is a possibility that could improve the markets”.

“Potential measures could include an extension of the maturity of the central bank liquidity provided to banks and purchases of private debt securities in the secondary market”.

Hallelujah.

Nout Wellink, governor of the Dutch central bank, in turn said there is now “an increasing risk of deflation”.

Thank you Mr Wellink.

ECB president Jean-Claude Trichet has been insisting for month after month that there is no risk whatsover of deflation. At least a million workers are going to lose their jobs over coming months unneccesarily because of this blind refusal to face the reality of what is happening in the world.

(Or perhaps that is unfair to Mr Trichet’s boss – Bundesbank chief Axel Weber. One suspects that Mr Weber does indeed understand what is happening but knows that once the ECB starts buying bonds, it is on the slippery slope to an EU debt union – at German expense. The pressure to bail out Club Med governments may become unstoppable. He is right about that.)

Mr Wellink went on to admit that the ECB had screwed up royally by raising rates last July in response to a phoney inflation scare (oil futures speculation) at a time when much of the eurozone was already in recession.

“In hindsight, this measure was based on a faulty estimate of inflationary risks and real growth prospects.”

Bravo, Mr Wellink. This is the first time – to my knowledge – that any ECB governor has admitted any fault in what must be described as the most remarkable act of monetary primitivism in modern times, or indeed admitted any error on anything. One was beginning to think they were incapable of self-criticism.

Thank goodness for Dutch honesty. The ECB will be much stronger for it. Chippy central banks do not command respect.

It has taken a long time to get here: a lot of damage has been done. A German contraction of 6pc to 7pc (Commerzbank forecast) is already baked into the pie this year. German unemployment may reach 5m in 2010 (RWI Institute).

Ireland’s GDP has already dropped 7.5pc (year-on-year to Q4). Eurozone Industrial output fell 17.3pc in January (y/y). It was down 31pc in Spain. This is a greater fall than anything suffered in Spain over a 12-month period during the 1930s.

Now, I am not going to take a view here, but I think you know my unease with printing money. And I do think the excess liquidity in the system will not be mopped up in due course when the global economy recovers.

What I want to focus on is the importance of the ECB’s move to a more explicit QE policy. In my view, this puts every major central bank into the same category i.e. printing money to ward off deflation. Irrespective of one’s ideological bent, one must this should mean recovery sooner rather than later. Whether this anticipated recovery is inflationary or ephemeral remains to be seen.

As for Evans-Pritchard’s piece, he does go on to say:

Sadly I have little confidence that the ECB will undertake QE with adequate dispatch, but at least they seem willing to swallow their pride and start to do their part to mitigate the global depression that we are already in.

If they move fast enough they may even prevent the eurozone breaking. Big if.

We all know he has an anti-Euro bias (one I often share), so you have to take his comments with a pinch of salt.

My conclusion is that we mustn’t discount the very real possibility of a cyclical upturn in 2009. While my base case view sees weakness through the end of the year, signs of reflation in asset prices, commodity prices, plateauing claims numbers, and consumer spending are certainly already evident.

Certainly, I still foresee some major writedowns and heavy challenges in stoking credit growth in North America and Europe. But, I will keep an open mind and look for evidence on both sides of this argument.

Sources
QE2 – Size Matters – Morgan Stanley
Europe fetches the monetary helicopters, at long last – Ambrose Evans-Pritchard, Telegraph

Related posts:

• Quantitative easing in the U.K.
• Nouriel Roubini: Will massive stimulus ward off stag-deflation?
• Is Japan next on the road to quantitative easing?
• Plosser: The Fed must stop qualitative easing
• Is quantitative easing really inflationary?

The remittanc income from Mexican and Central American immigrants working in the United States bck to their home nations is not the only huge remittance flow in the world.  One of significant import is in Europe, where millions of indivuals from the former Eastern Bloc now work in Western Europe.  However, as in the U.S. – Mexican connection, these remittances will be nosediving.

Below is an analysis from Morgan Stanley (with my boldng):

The Central European economies (Czech Republic, Hungary, Poland, Romania) are heavily influenced by developments in their richer western neighbors. Developed Europe accounts for around 70% of all CE exports; its banks dominate lending, with a market share of around 80% on average; and FDI inflows from western European companies have proved to be a significant engine of growth over recent years.

We look at yet another channel of contagion: remittances flows. In the years that followed EU accession (2004 for most accession countries; 2007 for Bulgaria and Romania), large numbers of migrants left their countries and migrated to core EU countries, in particular the UK, Ireland, Germany, Spain and Italy. Among the countries we look at in this piece, this issue is particularly relevant for Poland and Romania: large numbers of Poles migrated to the UK, Ireland and Germany, whereas Romanians migrated mostly to Spain and Italy. BoP data show that remittances inflows account for 4.5% of GDP in Romania and around 2% in Poland. They therefore ‘finance’ around a third of the overall C/A gap in both countries.

We think these remittances inflows will slow markedly in the coming months. This is due to the fact that economic conditions in the countries where most Poles and Romanians migrated to have turned sour, so there will be less money to send home. Also, especially for Poles in the UK, the slide in GBP makes working abroad less attractive: in 2004, GBP/PLN was trading at around 7.0; currently it is around 4.85, after approaching 4.0 last summer (when PLN strength was at its peak). Note, however, that the gap remains large.

I should also point out that Eastern European immigrants in countries like Ireland are getting the sack in droves as that economy has entered a depression. Nevertheless, this puts these individuals in a bit of a pickle because their home economies are facing equally severe downturns.

In my view, intra-EU immigration will become a larger problem within the Eurozone as this crisis unfolds.

See the link below for more of what Morgan Stanley has to say about the remittance issue.

Source
Dwindling Remittances – Pasquale Diana & Alina Slyusarchuk, Morgan Stanley

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• A bearish view on Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded

This comes from Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman (bolding in original).  Chandler does NOT see an imminent switch to  Euros in the offing, despite the recent musings by Chinese officials  (Neither do I.  However, I do believe the US dollar is a weak currency.  At a minimum, gold and oil should gain as the Fed monetizes debt):

A Reuters report out last week is still eliciting client queries. The report claims that a UN panel will recommend this week “that the world ditch the dollar as its reserve currency in favor of a shared basket of currencies”. A panel member, who’s currency hedge fund blew up because of the irrationality of the market (he said) was the apparent source of the leak.

Despite the drama, the UN panel recommendation is likely to fall flat. First, central bankers have the freedom to chose their reserve asset. The IMF COFER data clearly shows that those central bank that report their reserve allocation favor the dollar by a little less than 2/3. The euro, which many thought would or could replace the dollar remains roughly the size of its constituent parts (ECU, Deutschemark and French franc). Moreover, given the dollar’s decline since 2000, one might have expected that on valuation grounds alone the dollar’s share would have fallen by more.
In the Reuters story, the panelist asserts that the US is concerned that holding the reserve currency made it impossible to run policy. This claim is surely an exaggeration. The US has recognized the significance of having the numeraire by among other things, making dollars available in unlimited scale to world’s most important central banks and to a handful of central banks in emerging markets. Clearly too the support given to AIG has also found its way to numerous European entities. We have maintained that the IMF assistance programs have filled an institutional vacuum in Europe as all but one of its assistance programs have been aimed at European countries. In this context, the support the US have provided to AIG helps avert a deeper European banking crisis.

The panelist then suggests that “the rest of the world was also unhappy with the generally declining dollar.” This too seems exaggerated. The main problem over the last six months is not too weak of a dollar, but its opposite, too strong. The dollar’s appreciation aggravated the currency mis-match problem of a number of countries. If the world was as unhappy as the panelist claims, wouldn’t there have been a bigger exodus out of the dollar.

The Reuters story also indicates that the panelist has “long argued that the dollar would give way to the Chinese yuan as a global reserve currency within decades.”

While a new special drawing right (SDR) allocation from the IMF is possible, there does not seem to be strong calls to do so. SDRs were first created in the late 1960s and has since been used to settle inter-government obligations and an accounting unit. The SDRs though have not increased with world trade or cross border movement of capital and therefore plays a minor role in most countries’ reserves.

Perhaps what gives the UN story some play is that China is also seen calling for a new international reserve asset. The head of the PBOC Zhou Xiaochuan is taking the lead in the charge, but there are important but subtle differences. First, Zhou is talking about strengthening IMF supervision of developed countries as opposed to developing countries, where the focus is often. In particular China argues that the with power of seniorage that accrues to the reserve provider comes extra responsibility. In a joint statement with the Finance Ministry China argued that the supervision of the credit rating agencies and other financial institutions that have systemic influences should be strengthened.

Recall that US Treasury figures show that China increased its Treasury holdings by almost 40% in H2 08. It bought more in January. China officials recognizes the primacy of the US economy. It has not sought to undermine the dollar. It has arguably done as much as any country, if not more, for the strong dollar policy. China, like Russia, is beginning to encourage the some domestic firms to invoice in yuan (or rubles), but this is quite different than actively pursuing a reserve currency status.

Just as importantly is what China is not saying. It is not saying it will dump dollars. It is not saying it will buy more euros. The support for a new international reserve assets seems to be an attempt to get around the Triffin Paradox (the contradictory pressures on a national currency that is also a reserve asset). However, these are longer-term issues.

UN headlines can hit anytime over the next few days. Do not be surprised. Do not expect of a large response and if there is, it won’t be sustained. The UN does not have the same clout on financial issues as the IMF. A small group of US critics could capture a platform for their own purposes. It has happened before. It could happen again.

Meanwhile, the dollar’s role seems as secure as ever. There is no clear national alternative and a new international asset cannot simply be foisted on countries. The dollar remains numeraire, imperfections and all.

Related posts:

• Is China avoiding using US dollars?
• Mea culpa on the need for a new currency
• China wants to get rid of the dollar
• Japanese defend dollar’s status while China tears it down
• Chinese to start settling trade in Yuan

While most people have their attention tuned to the spectacle over at AIG, financial institutions in Europe are having their own difficulties. In the last day, I have seen multiple news stories of European banks looking for ways to raise capital in order to shore up their weakening balance sheets. Let me focus on three stories in particular: Nordea, Bank Austria and HVB.

This story about Nordea comes via the Danish paper Berlingske Tidene. Below is my translation (note my highlights):

On Friday Nordea will offer 1,430,059,525 shares to existing shareholders, with the drawing taking place from 20 March to 3 April. The price of a stock is set at 13.5 dollars – less than half of Monday’s closing price of 29.4 dollars per share.

A rights issue has put the share price under pressure, because more shares dilute the value of the existing. But the dilution already happened last week, according to Nordea, when the conditions for drawing the right came out. Nevertheless, there may well be a moderate pressure on the stock price for a few days yet.

Existing shareholders who do not want to buy more Nordea shares can sell subscription rights. It requires 20 warrants to be able to buy a Nordea share.

On 17 April, Nordea will publish the final breakdown of who has bought how many shares.

My take on this news is that Nordea, weakened by exposure to loan losses in the Baltics, is a forced seller of shares. They need the capital because a tsunami of losses is about to hit shore and they want to have adequate capital with which to resist the wave. These maneuvers will add nearly 23 million kroner of capital to Nordea’s capital base (over 3 billion USD at an exchange rate of 6.72 NOK/USD).

Next up is Bank Austria. They have the same problem. Huge expected exposure to Eastern Europe, problems in Ukraine being a big factor (333 million euros in writedowns). But rather than try and issue shares, Bank Austria is going directly to the government to get bailout funds.  Below is a translation of a Kurier article:

Bank Austria may apply for a maximum of 2.7 billion euros in state aid. With this amount, the equity participation of the Republic of Austria for the bank reaches its cap as measured by balance sheet ratios. To bring the government’s return to 8 per cent – it will be exclusively ‘participation’ capital – the bank will need a participation of 30 percent  ”private” capital.  Erich Hampel, the bank boss, is convinced that this will succeed.

When UniCredit CEO Alessandro Profumo spoke of the 2.7 billion euros, which Bank Austria, the business responsible for Eastern Europe, could receive from the Austrian government, Hampel only wanted to address a sum which was theoretically possible in state aid — which when weighted at 2 percent of risk assetsworks out arithmetically to 2.7 billion euros, accoring to his company.

Why is Bank Austria getting money from the government? Because UniCredit, its parent, is hemmoraghing losses. Just today, the German subsidiary HVB Group announced a loss of nearly 700 million euros due to writedowns due to exposure to… you guessed it, Eastern Europe. As a result, UniCredit needs cash from both the Austrian and Italian governments. The FT explains:

UniCredit, one of Italy’s top two banks, is to seek up to €4bn in state aid, joining a growing list of European banking groups turning to governments to boost their capital base as they grapple with the global financial crisis.

The bank, which has expanded into central and eastern Europe and as far as Kazakhstan in the past decade, said on Wednesday it would ask the Italian and Austrian governments for the cash.

Austria is already in talks about investing in Raiffeisen, the third largest Austrian bank, and Italy has approved a €12bn scheme that would see the state buying bonds issued by Italian banks.

UniCredit, which by some measures is the biggest lender in central and eastern Europe, announced the move as it reported 2008 annual results that were ahead of market expectations.

Results ahead or not, given UniCredit’s outsized exposure to Eastern Europe – a subject of much speculation – I have a feeling that the UniCredit story will start to become a front page item soon enough.  Nordea may escape that fate.  Of course, all of this is wholly predictable.

Sources
1,5 milliarder nye Nordea-aktier på fredag – Berlingske Tidene
Bank Austria will 2,7 Mrd. Euro vom Staat – Kurier
Here We Go Time Draws Near With Unicredit – Edward Hugh
UniCredit’s HVB Has EU671 Million Loss on Writedowns – Bloomberg.com
UniCredit seeks €4bn aid – FT.com
Bank Austria mit 1,1 Milliarden Gewinn – Standard Austria

Related posts:

• Quote of the day: Austrian banks
• Is this Austrian real estate company a canary in the coalmine?
• EU planning 200 billion euro package for Eastern Europe
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• Earnings results at Swedish banks show large writedowns in Baltics

After Europe emerged from the worst war in human history, its cities lay in ruins. Its economy was in tatters. It was in this environment that an Iron Curtain fell over Europe dividing it into east and west, separating Europeans from each other for four decades. Now, another twenty years later, we risk another great divide in Europe, the Ukrainian Prime Minister Yuliya Tymoshenko has warned.

Below is my translation of a German-language article in Austrian daily Der Standard. 

The Ukrainian Prime Minister Yuliya Timoshenko warned in a newspaper commentary of a new “Iron Curtain” in Europe and calls on the European Central Bank to support those countries not in the euro zone. The euro should not lead to an Iron Curtain, which puts non-Euro countries into a  higher risk class, which investors would no longer dare trust, Timoshenko wrote in Le Figaro.

Ukraine has asked the International Monetary Fund (IMF) for emergency aid to stabilize the economy. The country has been hit hard by the global crisis. The currency has lost more than 40 percent of its value since the autumn. The IMF, however, has delayed the transfer of the second loan tranche of a total of 16.4 billion U.S. dollars (13 billion euros) and called on the country to make its crisis management more urgent.

After the Fed also offered currency swaps to Brazil, Mexico and South Korea, Tymoshenko has  called for a similar scheme in Europe: “The ECB should also provide access to these tools to countries outside the monetary area.”

My view here is that Tymoshenko is going to be one of the last countries in the queue, so she had better demonstrate some seriousness about managing this crisis domestically or even the monies promised by the IMF will not be forthcoming.  The EU has its hands full with the Baltics and Central Europe, not to mention Club Med’s economic woes and Ireland and Austria’s banking crises.

Does this mean a new ‘Iron Curtain’ is forming?  I doubt it.  However, one should be very concerned here given the strategic importance of Ukraine as a transit route for gas.  Having them fall into the abyss is good for no one in Europe.

By the way, the term Iron Curtain comes from a famous 1946 speech by Winston Churchill:

From Stettin in the Baltic to Trieste in the Adriatic an “iron curtain” has descended across the Continent. Behind that line lie all the capitals of the ancient states of Central and Eastern Europe. Warsaw, Berlin, Prague, Vienna, Budapest, Belgrade, Bucharest and Sofia; all these famous cities and the populations around them lie in what I must call the Soviet sphere, and all are subject, in one form or another, not only to Soviet influence but to a very high and in some cases increasing measure of control from Moscow.

Sources
Timoschenko warnt vor einem neuen “Eisernen Vorhang” – Standard Austria
Iron Curtain – Wikipedia

Related posts:

• Russia cuts Europe off completely from its gas
• FT: Ukraine must pay Russia market prices for gas
• Russia: playing chicken with Ukraine over natural gas
• Ukraine: economy shrank 25-30% in first two months
• EU planning 200 billion euro package for Eastern Europe

About a week ago I reported on an Austrian story that the EU was gearing up for a bailout of any eurozone members which found themselves in difficulty (see my post, “EU planning 200 billion euro package for Eastern Europe“. This report is now being confirmed by multiple sources including Joaquin Almunia, the economics commissioner of the European Union.

Ambrose Evans-Pritchard of the Telegraph writes:

Joaquin Almunia, the economics commissioner, said EMU economies in distress can count on EU solidarity if they get into trouble, rather than having to go cap in hand to the International Monetary Fund.

“It is clear that there are serious problems in certain countries. If a crisis emerges in one eurozone country, there is a solution before visiting the IMF. We are equipped intellectually, politically and economically to face this crisis scenario. It’s not clever to tell you in public. But the solution exists,” he said.

Mr Almunia said the probability of a eurozone break-up is “zero”, despite the surge in interest spreads on Greek, Irish, Austrian, and Italian 10-year bonds above German Bunds. “Who is crazy enough to leave the euro area? Nobody. The number of candidates to join is growing,” he said.

Officials are keeping a close eye on renewed stress in Europe’s credit markets. The iTraxx Crossover index measuring default risk on low-grade corporate bonds jumped above 1,100 yesterday, nearing the panic levels after the Lehman collapse last year.

Certainly, downturns in Greece, Ireland and Spain are part of this. However, at issue here as well is the recent acknowledgement by market participants that there is serious exposure in countries like Austria to downturns in Central Europe, the Balkans, and the Baltics and Eastern Europe.  Some of those countries are doing their own PR campaign in order to distance themselves from their more challenged EU brethren.

The central banks of the Czech Republic, Bulgaria, Poland, Romania and Slovakia have issued a joint statement defending their economies.

They said that recent warnings about their economies were “misleading”.
Eastern European countries have come under scrutiny in recent weeks amid fears about their economic prospects and reliance on foreign debt.

The countries’ currencies and stock markets have also fallen sharply as the downturn has intensified.

Mixed picture
Hungary’s central bank later said it supported the statement issued by it counterparts.
The central banks urged investors to look at the prospects of individual countries and not assume that Eastern Europe was a “homogenous region”.

Better-off countries like Czech Republic and Poland feel that they are unfairly lumped together with places such as Hungary or Latvia, which have been particularly hard hit.
They expressed concern at the warnings made recently made by credit ratings agencies and other bodies, saying it could undermine financial stability in the region.

I see these statements from some governments in Eastern Europe as self-serving and an every-man-for-himself action which can only divide Europe as it seeks to deal with this crisis.

Ultimately, everyone is looking to Germany here. The Germans have deep pockets and are the largest EU member. For weeks, much speculation has centred on whether the Germans would bail out another eurozone member in trouble. Now, we see they just may. How this plays out with the German politicians’ domestic constituency gearing up for national elections is another story.

Sources
EU pledges eurozone rescue – Ambrose Evans-Pritchard, Telegraph
East Europe banks back economies – BBC News

Related posts:

• The Eurozone and the spectre of banking collapse
• EU planning 200 billion euro package for Eastern Europe
• Remittances to Eastern Europe to slow dramatically
• Peer Steinbrueck says Germany might bail out the Austrians
• The case against the Euro

The following article comes from Absolute Return Partners’ Niels Jensen. Absolute Return Partners LLP is a London based private partnership which provides independent asset management and investment advisory services globally to institutional as well as private investors, charities, foundations and trusts. Visit www.arpllp.com to learn more about them.  You can reach them by email at info@arpllp.com.

Update 05 Mar 2009: I should note that Niels makes mention of edits to an article in the Telegraph about European toxic asset exposure which I also spotted in my post “Are European banks sitting on 16.3 trillion in toxic assets?”

Now, Niels Jensen:

The Absolute Return Letter March 2009

“Many of today’s policy proposals start from the view that “greed” and “incompetence” and “poor risk assessment” are the ultimate source of what went wrong. In fact, they were not the true cause at all. Moreover, even if they had been, it is fatuous to think that we will now create a post-crash generation of bankers and traders who are not greedy, much less a new generation of quants who will be able to assess and manage risks much better than “the idiots” who have brought us to the current abyss. Greed cannot be exorcised. Nor can the inherent inability of any quants to determine the “true” probability distributions of all-important events whose true probabilities of occurrence can never be assessed in the first place.”

Woody Brock, SED Profile, December 2008

Policy mistakes ‘en masse’

The last few weeks have had a profound effect on my view of politicians (as if it wasn’t already dented). All this talk about capping salaries for senior bank executives is quite frankly ridiculous. It is Neanderthal politics performed by populist leaders. That Gordon Brown has fallen for it is hardly surprising but I am disappointed to see that Barack Obama couldn’t resist the temptation. The mob wants blood and our leaders are delivering in spades. The stark reality is that we are all guilty of the mess we are now in. For a while we were allowed to live out our dreams and who was there to stop us? Policy mistakes – very grave mistakes – permitted the situation to spin out of control. From the U.S. Federal Reserve Bank under the stewardship of Alan Greenspan being far too generous on interest rates to the British Chancellor of the Exchequer -who now happens to be our Prime Minister – advocating ‘Regulation Light’.

Policing must improve

If you really want to prevent a banking crisis of this magnitude from ever happening again, the focus should be on the way banks operate and not on how much they pay their staff. And, within that context, any discussion must start and end with how much leverage should be permitted. The French have actually caught onto that, but their narrow-mindedness has driven them to focus on hedge funds’ use of leverage which is only a tiny part of the problem. It is the gung ho strategy of banks which brought us down and which must be better policed. And guess what; if banks were better policed – and leverage restricted – then profits, even at the best of times, would be much smaller and there would be no need to regulate bankers’ compensation packages.

It is pathetic to watch our prime minister attacking the bonus arrangements of our banks when the UK Treasury, on his watch, spent £27 million pounds on bonuses last year as reward for delivering a public spending deficit of 4.5% of GDP at the peak of the economic cycle. Even my old mother understands that governments must deliver budget surpluses in good times, allowing them more flexibility to stimulate when the economy hits the wall. What Gordon Brown has done to UK public finances in recent years is nothing short of criminal.

So, with that in mind, let’s take a closer look at the European banking industry. The following is not pretty reading. I have rarely, if ever, felt this apprehensive about the outlook. So, if the crisis has made you depressed already, don’t read any further. What is about to come, will make your heart sink.

More leverage in Europe

Let’s begin our journey by pointing out a regulatory ‘anomaly’ which has allowed European banks to take on much more leverage than their American colleagues and which now makes them far more vulnerable. In Europe, unlike in the US, it is only risk-weighted assets which matter to the regulators, not the total leverage ratio. European banks can therefore apply a lot more leverage than their US counterparties, provided they load their balance sheets with higher rated assets, and that is precisely what they have been doing.

That is fine as long as you buy what it says on the tin. But AAA is not always AAA as we have learned over the past 18 months. Asset securitisations such as CLOs proved very popular amongst European banks, partly because they offered very attractive returns and partly because Standard & Poors and Moodys were kind enough to rate many of them AAA despite the questionable quality of the underlying assets.

Now, as long as the economy chugs along, everything is dandy and the AAA-rated assets turn out to be precisely that. But we are not in dandy territory. Many asset securitisation programmes are in horse manure to their necks, so don’t be at all surprised if European banks have to swallow further losses once the full effect of the recession is felt across Europe. The two largest sources of asset securitisation programmes are corporate loans and credit cards. Senior secured loans are still marked at or close to par on many balance sheets despite the fact they trade around 70 in the markets. The credit card cycle is only beginning to turn now with significant losses expected later this year and in 2010-11.

Not much of a cushion left

Citibank has calculated that it would only take a cumulative increase in bad debts of 3.8% in 2009-10 to take the core equity tier 1 ratio of the European banking industry down to the bare minimum of 4.5%¹. By comparison, bad debts rose by a cumulative 7% in Japan in 1997-98. One can only conclude that European banks are very poorly equipped to withstand a severe recession. Seeing the writing on the wall, they are left with no option but to shrink their balance sheets. Despite talking the talk, banks will use every trick at their disposal to reduce the loan book. No prize for guessing what that will do to economic activity.

The wheels are coming off

But that is not the whole story. It is not even the most worrying part of the story. For the true horror to emerge, we need to turn to Eastern Europe for a minute or two. Nowhere has the credit boom been more pronounced than in Eastern Europe. And nowhere is the pain felt more now that credit has all but dried up. One measure of the credit fuelled bonanza is the deterioration of the current account across the region. Credit Suisse has calculated that in four short years, from 2004 to 2008, Eastern Europe’s current account went from +6% to -6% of GDP². That is a frightening development and is likely to cause all sorts of problems over the next few years.

Meanwhile Western European banks, eager to milk the opportunities in the East after the iron curtain came down, have acquired many of the region’s banks (see chart 1). Now, with many Eastern European countries in free fall, ownership could prove disastrous for an already weakened banking industry in the West.

The problem is widespread

To make matters worse, the problems in the East are beginning to look systemic. Credit Suisse has produced an interesting scorecard where they rank a number of countries around the world on factors usually taken into consideration when assessing the credit quality of sovereign debt (see chart 2). At the top of the tree (i.e. the worst credit score) you find Iceland – hardly surprising considering their current predicament. More importantly though, of the next 14 countries on the list, 8 are Eastern European – not what you want to hear if you are an already undercapitalised European bank with huge exposure to Eastern Europe.

Swedish banks are already reeling from their exposure to the Baltic countries. Austrian banks are in even worse shape, having been the most acquisitive of any European banks. Some Italian banks could be dragged under by their Eastern European exposure and even the conservative banking sector in Switzerland doesn’t look like it can escape the mayhem.

Worst of all, the problems in the East are just about to unfold at a point in time where the European banking industry is bleeding heavily from massive losses already incurred in other areas. With no access to private funding, banks find it virtually impossible to re-build their capital base with anything but tax payers’ money.

US banks are better off

US banks are in less of a pickle. Unlike the subprime debacle which hit both the US and the European banks hard, US banks have little exposure to Eastern Europe. To prove my point, according to the IMF, European banks have 75% as much exposure to US toxic debt as American banks, but 90% of all cross border loans to Eastern Europe originate from Western European banks. And, to add insult to injury, European banks have been much slower than US banks in terms of recognising their losses. Write-offs now total about $750 billion in the US and only about $325 billion in Europe.

The great mortgage show

The problems in Eastern Europe begin and end with their large external debts. In recent years, ordinary people all over the region have converted their traditional mortgages to EUR- or CHF-denominated mortgages. Some have even switched to JPY mortgages. Who can possibly resist 3% mortgages? Didn’t anyone inform them of the risk? As currencies across the region have fallen out of bed in recent months, these mortgages have suddenly become 30-50% more expensive. No wonder the local economy is suddenly tanking.

Credit Suisse has calculated that net foreign liabilities (as a % of GDP) have risen from 47% to 65% in recent months as a direct result of the loss of local currency values (see chart 3 – and don’t ask me why Credit Suisse has included South Africa in Eastern Europe!).

Chart 4: Eastern European vs. Asian Crisis

Source: Wall Street Journal

Back in 1997-98 Asia went through a similar currency crisis. However, as you can see from chart 4, Asian current account deficits were much smaller than Eastern European deficits are now. So were debt levels. Despite that, the Asian crisis did enormous damage to the local economy. Eventually Asia came good, primarily because the devalued currencies allowed the Asian countries to export more. Eastern Europe does not share this luxury. With over 90% of the world’s GDP in recession, who are they going to export to anytime soon?

Austria is in greatest trouble

According to the latest estimates from BIS, Eastern European countries currently borrow $1,656 billion from abroad, three times more than in 2005 and mostly denominated in foreign currencies (ouch!). 90% of that can be traced to Western European banks. About $350 billion must be repaid or rolled over this year. Not an easy task in these markets. Austrian banks alone have lent about $300 billion to the region, equivalent to 68% of its GDP according to the Financial Times. A default rate of 10% on its Eastern European loans is considered enough to wipe out the entire Austrian banking system. EBRD has gone on record stating that defaults in Eastern Europe could end up as high as 20%³.

An extra $250bn to the IMF

Hungary, Latvia and Ukraine have already received emergency loans from the IMF and both Serbia and Romania are reportedly considering asking for help. Meanwhile the IMF’s coffers are draining quickly and it has asked leading industrial nations for new funding. At their summit a week ago, EU leaders coughed up an extra $250 billion but nobody said where the money is going to come from. Even if they find the money, it is likely to prove hopelessly inadequate. Our leaders must grow up. Measuring everything in billions is so yesterday. Trillions are the new billions, like it or not.

Conspiracy or…?

On the 11th February the Daily Telegraph’s Brussels correspondent Bruno Waterfield wrote an article under the header: “European banks may need £16.3 trillion bail out, EC document warns.” In the article, the reporter revealed that he has seen a secret document produced by the EU Commission which briefed the union’s finance ministers on the true extent of the banking crisis. Less than 24 hours later, the article’s header was changed to “European bank bail-out could push EU into crisis” and two paragraphs had mysteriously disappeared. Here they are:

“European Commission officials have estimated that “impaired assets” may amount to 44pc of EU bank balance sheets. The Commission estimates that so-called financial instruments in the ‘trading book’ total £12.3 trillion (13.7 trillion euros), equivalent to about 33pc of EU bank balance sheets.

In addition, so-called ‘available for sale instruments’ worth £4trillion (4.5 trillion euros), or 11pc of balance sheets, are also added by the Commission to arrive at the headline figure of £16.3 trillion.”

Do yourself a favour – read those two paragraphs again. Newspaper editors do not change content light-heartedly. Did the Telegraph editor receive a call from Downing Street? Or Brussels? Did he have second thoughts about the avalanche that he could possibly instigate? I don’t know and I probably never will. But one thing is certain. If the EU Commission’s estimate of £16.3 trillion of impaired assets is correct, then the crisis is far worse than any of us could ever imagine. Not only would we have to get used to the prospects of a systemic meltdown of our banking system, but entire nations may go down as well.

Public debt to rise and rise

Even if actual losses prove to be much, much smaller (and I sincerely hope so), the banking sector cannot, in the current environment at least, raise sufficient capital to stay afloat, so more, possibly a lot more, tax payers’ money will have to be put forward. This can only mean one thing. Public debt will rise and rise. The official estimate for the UK for next year is already approaching 10% of GDP, an estimate which will almost certainly rise further. We probably have to get used to running 10-15% deficits for a few years, a fact which seriously undermines the notion of government bonds being next to risk-free.

BCA Research has calculated the effect on public debt in a number of countries, as a result of further bank losses being underwritten by tax payers. Obviously, those countries with the largest banking industries (as a % of GDP) will be hit the hardest (see charts 5a and 5b).

For that very reason, and as pointed out in last month’s Absolute Return Letter, there is a real risk that investors will demand much higher risk premiums on government debt. Only a few days ago, Ireland issued 3-year bonds at almost 250 basis points over corresponding Bunds. As more and more debt is transferred to sovereign balance sheets, we will likely see the spreads between good and bad paper rise further but we will also witness increasingly desperate measures being applied by the men in power. If they could prohibit short-selling of banks on the stock exchange (which didn’t work), why wouldn’t they consider prohibiting short-selling of government bonds? Not that it would necessarily work any better, but desperate people do desperate things.

Can Germany rescue us?

Most investors remain convinced that Germany will come to the rescue – in my opinion not as simple a solution as widely perceived given the enormity of the crisis. One possible solution which has been mentioned frequently in recent weeks is for all the eurozone nations to get together and start issuing joint bonds. This would undoubtedly help the weaker nations, but the idea was shot down by the German Finance Minister only a few days ago when he said that closer economic harmony across the eurozone would be needed before Germany would be prepared to entertain such an idea.

The most obvious trick left in the book, therefore, is to inflate us out of this mess. With the enormous amounts of public debt being created at the moment, years of deflation a la Japan would be catastrophic. You will never get a central banker to admit to it, but a healthy dose of inflation is probably our best prospect of surviving this crisis.

Given this outlook, do you really want to be long euros?

Niels C. Jensen 

Related posts:

• EU planning 200 billion euro package for Eastern Europe
• UBS does not see the need for panic over Eastern Europe
• Bloomberg talks Eastern Europe as Latvia downgraded
• EU: Banks ask for a bailout for poor lending in Eastern Europe
• European banks: still undercapitalised