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from MacroScope:

The dangers of a bloated ECB balance sheet

Central balance sheets across the industrialized world have increased rapidly in response to the financial crisis, as recently noted on this blog. In Europe, the balance sheet of the ECB and the 17 national central banks that share the euro currency has grown to around 3 trillion euros after the ECB injected more than a trillion into the market in 3-year loans and loosened its collateral standards.

At above 30 percent of gross domestic product, the ECB's balance sheet has overtaken that of the Bank of Japan, which has been grappling with deflation for some two decades and started from a much higher level. It is also bigger than that of the U.S. Federal Reserve, which has aggressively responded to two financial crises in five years by tripling the size of its balance sheet to nearly $3 trillion today.

Historically, a central bank's job is to maintain price stability and the value of its currency. The ECB's non-standard measures have aimed to do just that as the euro zone debt crisis threatened the viability of the euro currency. But a growing and deteriorating balance sheet also comes at a price.

Julian Callow, head of international economics at Barclays explains:

The more the balance sheet rises, the more the ECB has exposure to the euro zone banking system, particularly of course the banking system in countries which are having difficulty in generating private sector financing.

from MacroScope:

An eerie euro zone calm

I don’t want to be the idiot who asked “is it all over?” … but is it all over?

Almost certainly not, is the answer. Greece is shored up for now but Portugal will probably need to follow it in seeking a second bailout and Spain, heading back into recession, will have to make deep, deep cuts over the next two years to meet EU deficit targets. Greek and French elections could easily upset the apple cart, the former producing a fractured government with less will to tread the austerity path, the latter a new president who wants to renegotiate the bloc’s new fiscal rules (though neither are guaranteed).

In Italy, a lot of faith continues to be placed in Monti but the proof of his ability to deliver the structural reforms needed to regalvanise the economy has yet to be seen. On that front, the Italian government is talking with trade unions during the week on radical reform of labour market rules, with the aim of clinching a deal next week.

There are a number possible potholes for the euro zone’s new fiscal pact not just in France -- an Irish referendum (they’ve lost those before), signs of the Dutch governing coalition splintering over the issue as well as Francois Hollande’s vow to renegotiate it for France. And Germany has not yet dropped its opposition to a larger bailout fund and now faces complicated regional elections.

Even if all the stars are aligned, Italy, Spain, Portugal (let alone Greece) face years of economic hardship before the reforms bear fruit and cuts are finished with. The ECB’s wall of money and the likelihood that a strong euro zone firewall will be in place by mid-year have clearly reduced the existential threat to the currency bloc substantially. But so much of this is to do with market sentiment, currently benign, that it’s not hard to construct a scenario later this year where it could sour again.

While Greece is now firmly in election mode, on Monday the default insurance taken out on Greek bonds will be settled. It looks like around a net $2.5 billion will be paid out, not remotely threatening in a systemic sense. The question is: Is there a bank out there with a horribly exposed position?

For now, for crisis junkies – which most of us have become – there’s a slightly unnerving calm taking hold. Markets, having gorged on central bank cash, are firmly in glass-half-full mode, maybe three-quarters full. The three big disaster hedges – gold, AAA debt and volatility indices – are all now in full retreat. On the other hand, stocks and other assets have rallied hard since the start of the year and can’t do that forever.

from MacroScope:

Today in the euro zone

The Greek bailout is done and Spain and the EU have struck a face-saving compromise over what deficit Madrid should aim for this year, so all is well with the world. That certainly seems to be the market mood this morning with safe haven German Bund futures opening sharply lower and European stock futures pointing to further gains. In fact, the tone is more to do with the Federal Reserve, which sounded somewhat more upbeat about the U.S. economic outlook last night and said most banks (with the exception of Citi!) had passed tough stress tests, though it’s also true that there is nothing on the euro zone horizon today to spoil the party.

Italy comes to market with its latest bond auction. Investors flush with cheap European Central Bank funds are expected to pile in, pushing three-year borrowing costs below 3 percent. Rome is taking advantage of the current benign conditions to try and sell up to six billion euros of debt.

More interesting may be tomorrow’s Spanish auction. Italian premier Mario Monti remains the euro zone’s austerity poster boy, in contrast to Mariano Rajoy. Although the new Spanish prime minister has successfully negotiated a looser deficit target with Brussels, the downside of that deal is that Madrid might come under more scrutiny, particularly if it looks like missing that softer target.

Nonetheless, if we wind the clock back to the beginning of the year, everybody was fretting about Italy facing a mountain of refinancing (with the same true of Spain to a lesser extent) and now it looks like no more than a small bump in the road thanks to the ECB’s largesse.

The level of hope pinned on Monti to keep Italy out of the mire (failure to do so would push the currency bloc back into existential threat territory) allows him to press his case for strong growth measures to run alongside the austerity drive. He did so again with Angela Merkel last night. That still requires more domestic spending by Germany, Europe’s largest economy.

French President Nicolas Sarkozy (who latest polls suggest should certainly not be written off at next month's presidential election) seems to be on the same page as Monti saying this morning, with reference to Spain: “The choice is not between deficit reduction and growth, the choice is growth and deficit reduction." Even with its new target, Spain, already in recession and with almost half its youth out of work, is going to have to find deep cuts this year which are likely to make things worse. The same applies in spades to Greece.

from John Lloyd:

Europe’s welfare rock has made it a hard, undemocratic place

Speak now to an intelligent European politician (having assured him or her that the conversation is off the record) and you will discover a deeply worried representative -- and one who leaves you in a similar state. Whether they are in the European parliament or a national legislature, European politicians are now constrained to contemplate their powerlessness. And ours.

Ordinary members of parliaments often feel like that. But ministers, even of small states, who have been elected to represent, propose, plan and legislate, now feel it too, and more acutely. Especially in the countries that remain devoted to the idea that the state should protect its people from the hardships and, in some cases, the vicissitudes of life, people have been accustomed to expect much more in the way of protection. But politicians must now offer less. For many citizens, that provision, coupled with security, was the point of government. But now, as each week brings little respite, ministers, prime ministers and presidents feel powerless.

In part this is because one state, Germany, emasculates all others. It acts — nominally — with France, but the latter's weakened economy and politically weaker president, Nicolas Sarkozy, makes the duopoly at the apex of the European Union one of the weak providing political cover for the strong more than a true meeting of equals. On Angela Merkel's decisions, and those of the German parliament, hangs the fate of nations. She has not wished it so: Those who make the parallel between the Nazi savagery of 70 years ago and Germany's present power indulge in a facile radicalism that owes nothing to observable reality. Yet however reluctantly, she disposes for a continent.

This reduces politicians in other states to colonial administrators, constrained to follow the policies determined by Berlin, endorsed by France, and proclaimed as inevitable by prevailing economic opinion. It means that when their unions demonstrate, their small businesses cry for help, their students grow hopeless about jobs and careers, and their vulnerable and aging citizens grow fearful for their supports and pensions, they can only say: It will pass, we will return to growth and the good times will roll once more. And yet they don't know if it's true.

They are paralyzed, caught between two sets of headlights bearing down upon them. Germany has decreed that all members of the euro zone sign on to a pact that will make  the economic and financial levers of national governance dependent on a central EU power -- a move on which the European citizens are not to be consulted and that comes at a time when there is a gathering revulsion against the Union.

To say it is undemocratic is to say the obvious. In the member states, parties of the far right and left, long hostile to the EU, denounce it at meetings and in statements. The strongest of the extremists of the right, Marie Le Pen's Front National party, which poses a real threat to Sarkozy's ability to remain on the ballot through to the second round of France's presidential election in April, has soft-pedaled its racism but accelerated its anti-Europeanism. One of its militants, a translator named Guy Rondel, was quoted in the Financial Times this week as saying that "I think we should leave Europe. They decide everything and we have no say." How much that remains a minority view depends on the success of the French president’s Merkel maneuver. Failure would play well for Ms. Le Pen.

from The Great Debate UK:

Hungary: The Greece of Eastern Europe

By Kathleen Brooks. The opinions expressed are her own.

It used to be Greece that was the canary in the coal mine, these days it's Hungary. The new year got off to a bad start for the Eastern European nation after it experienced a failed bond auction, causing its bond yields to surge.

This caused major jitters across global financial markets and once again a small, relatively unknown economy is dominating the headlines and causing a massive headache for the European authorities.

But while there are many similarities, the reasons for the panic in Hungary’s debt markets are different from Greece’s problems. Athens borrowed too much and public spending spiralled out of control. However, Hungary’s problems were not based on the size of its budget deficit, which was a fairly manageable 4.2 percent of GDP at the end of 2010, but the amount of debt in its public and private sector that was denominated in foreign-currency.

While the post-Communist era in Hungary helped to modernise the state, its capital markets did not keep up to date. Borrowing costs were lower in the euro zone and other parts of Europe where banks were willing to lend relatively cheaply across the Eastern European bloc, especially to Hungary. While the Hungarian forint was strong it was fine to have liabilities in euro and Swiss franc, however, since the start of 2011 the forint has deteriorated at a rapid pace. Since August alone the forint has lost more than 17 percent of its value against the euro.

Here is the problem: when your liabilities are in euro but you earn forint, all of a sudden servicing your debts becomes much more expensive and bad debts start to rise.

That’s where the similarities with Greece start. If bad debts start to rise then Austria and Italy could be on the hook. Austrian banks hold a whopping $40 billion of Hungarian liabilities, while Italian banks have a slightly more manageable $20 billion.

from Expert Zone:

There is no place like home

(Paul Donovan is a Managing Director and Global Economist at UBS. The views expressed in this column are the author's own and do not represent those of Reuters)

Most economists believe that nearly everything in this life can be reduced to an economic explanation.

This even applies to popular culture. The Wizard of Oz has been explained as a parable of late 19th century economics, as a veiled commentary on the gold standard versus the use of silver that dominated the 1896 presidential election in America. The yellow brick road is gold, the cowardly lion was William Jennings Bryan (a pro-silver politician). The wicked witches represented Wall Street (east) and railroad interests (west). Dorothy had to put on silver shoes to make her way to the Wizard of Oz (the U.S. President). She then learned that she could escape the bizarre, fantasy world of Oz and get back to reality by clicking her heels and repeating “I want to go home”.

Confronted by the bizarre, fantastic world of the Euro today, investors could learn from the Wizard of Oz. Global investors may well want to click their heels and mutter “I want to go home”. After two decades of globalising capital flows, investors may once again feel the urge to have their money at home, or at least closer to home than has been the case hitherto.

Why should investors favour home or regional markets? In a rational world, investors should search for the best risk adjusted returns they can find, and put their money there. However, as the Euro only too clearly demonstrates, we do not live in a rational world.

There are two forces at work here. The first is the fact that political risk is playing a larger and larger role in the world’s financial markets. Governments have an increasing impact through regulation, government debt (and default fears), intervention in currency and bond markets and policy statements.

What this means is that the performance of markets can no longer be interpreted through economic activity alone. Increasingly, one must understand the political environment and the likely changes that that environment may bring to bear on investments. For many investors this is a development that they have not experienced before: political risk was a declining force in financial markets in the two decades that preceded the global financial crisis. The problem is that political risk is very often specific to a country or to a culture.

from Global Investing:

Contemplating Italian debt restructuring

This week's evaporation of confidence in the euro zone's biggest government debt market -- Italy's 1.6 trillion euros of bonds and bills and the world's third biggest -- has opened a Pandora's Box that may now force  investors to consider the possibility of a mega sovereign debt default or writedown and, or maybe as a result of,  a euro zone collapse.

Given the dynamics and politics of the euro zone, this is a chicken-or-egg situation where it's not clear which would necessarily come first. Greece has already shown it's possible for a "voluntary" creditor writedown of  the country's debts to the tune of 50 percent without -- immediately at least -- a euro exit. On the other hand, leaving the euro and absorbing a maxi devaluation of a newly-minted domestic currency would instantly render most country's euro-denominated debts unpayable in full.

But if a mega government default is now a realistic risk, the numbers on the "ifs" and "buts" are being being crunched.

In that light, Mark Schofield and Jamie Searle, strategists at U.S. investment bank Citi,  on Thursday attempted to figure out "fair value" for Italian government borrowing rates in the light of the week's dramatic events that saw 10-year yields on the bonds briefly top the "make-or-break level of 7% . Their conclusion was that Italian debt crunch was likely to get get a lot worse before it got better, absent a "significant and sizeable" political intervention.  By this, they are referring to the only scenario that they see would trigger a near-term turnaround -- open-ended ECB buying on a scale far greater than currently being seen.  However, they reckoned they still seems unlikely, for now.

What's left of the 440 bilion euro bailout fund is not big enough to rescue Italy -- where more than 300 billion euros needs to be found next year alone to pay interest costs and replace maturing debt. And with the recently-agreed, leveraged-up version of that EFSF unlikely to be finalised until next monthat the earliest, the Italian market is left in limbo.

As a result, the Citi analysts say it's become impossible to assess fair value for the market based on macro  fundamentals such as debt stock, budget deficits, national growth, inflation and central bank interest rates. So, they reckon they have to apply a "recovery-based default model" that takes in hypothetical debt restructurings and default probabilities. Given the recent Greek example, the 50% debt haircut has inevitably become a reference point.

Given that scenario, they reckoned 10-year Italian borrowing rates would have to rise as high as 14.5% -- more than twice current rates -- to compensate for the risks.

from MacroScope:

Contemplating Italian debt restructuring

This week's evaporation of confidence in the euro zone's biggest government debt market -- Italy's 1.6 trillion euros of bonds and bills and the world's third biggest -- has opened a Pandora's Box that may now force  investors to consider the possibility of a mega sovereign debt default or writedown and, or maybe as a result of,  a euro zone collapse.

Given the dynamics and politics of the euro zone, this is a chicken-or-egg situation where it's not clear which would necessarily come first. Greece has already shown it's possible for a "voluntary" creditor writedown of  the country's debts to the tune of 50 percent without -- immediately at least -- a euro exit. On the other hand, leaving the euro and absorbing a maxi devaluation of a newly-minted domestic currency would instantly render most country's euro-denominated debts unpayable in full.

But if a mega government default is now a realistic risk, the numbers on the "ifs" and "buts" are being crunched.

Mark Schofield and Jamie Searle, strategists at U.S. investment bank Citi,  on Thursday attempted to figure out "fair value" for Italian government borrowing rates in the light of the week's dramatic events that saw 10-year yields on the bonds briefly top the "make-or-break level of 7% . Their conclusion was that Italian debt crunch was likely to get get a lot worse before it got better, absent a "significant and sizeable" political intervention.  By this, they are referring to the only scenario that they see would trigger a near-term turnaround -- open-ended ECB buying on a scale far greater than currently being seen.  However, they reckoned they still seems unlikely, for now.

What's left of the 440 bilion euro bailout fund is not big enough to rescue Italy -- where more than 300 billion euros needs to be found next year alone to pay interest costs and replace maturing debt. And with the recently-agreed, leveraged-up version of that EFSF unlikely to be finalised until next monthat the earliest, the Italian market is left in limbo.

As a result, the Citi analysts say it's become impossible to assess fair value for the market based on macro  fundamentals such as debt stock, budget deficits, national growth, inflation and central bank interest rates. So, they reckon they have to apply a "recovery-based default model" that takes in hypothetical debt restructurings and default probabilities. Given the recent Greek example, the 50% debt haircut has inevitably become a reference point.

Given that scenario, they reckoned 10-year Italian borrowing rates would have to rise as high as 14.5% -- more than twice current rates -- to compensate for the risks.

from MacroScope:

Italy bond spreads signal renewed concern

Spreads between Italian and German government debt are blowing out heading into a European Union summit on Sunday that investors are hoping will come up with some action to address the continent’s sovereign debt crisis. Spreads between 10-year Italian government debt and German bonds of the same maturity widened to 398 basis points on Thursday, making for the biggest gap since at least the fourth quarter of 1996, according to Reuters data.

Andrew Wilkinson, Miller Tabak’s chief economic strategist, expands on the implications:

You have to look back to March 1996 to see the spread's last excursion above 400 basis points. That was when Italian government was trying desperately to meet Maastricht criteria and join the euro. I'm left wondering how pleased they are with that outcome in today's market. They never bargained for a spillover from Greece lie this. With the French/German yield spread leading the way this week it looks like pressure will continue to build in to the weekend.

from Breakingviews:

Bank debt confusion makes an unwelcome comeback

By Peter Thal Larsen and Antony Currie The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The parallels between the current market turmoil and the 2008 meltdown become more striking by the day. The latest crisis throwback is the bizarre earnings boost created by banks’ deteriorating creditworthiness. UBS says widening spreads on its own debt added 1.5 billion Swiss francs to its bottom line in the third quarter. Accountants, rather than banks, are to blame. But financial firms are still inconsistent and selective when reporting this perversity.

Since 2007, banks have had to report changes in the fair value of their own liabilities. When the market price of debt falls, liabilities are, from an accounting perspective at least, reduced, allowing the company to recognise a profit. Conversely, rising bond prices produce a loss.

For banks, the effect was particularly pronounced in 2008. As credit spreads soared, many booked large one-off gains: Morgan Stanley enjoyed a $5.1 billion profit that year. Those benefits reversed when debt spreads subsequently tightened. Now that markets are tumbling again, lenders are reaping spurious benefits. For UBS, the gain partly offsets the $2.3 billion hole left by its rogue trader, allowing it to report a modest, but psychologically important, net profit for the quarter.

Bank regulators ignore this accounting quirk: gains and losses on debt are excluded from capital calculations. But not all banks are equally transparent. Some have shown tendency to emphasise the losses while downplaying the gains. In 2007’s third quarter, Lehman Brothers quietly used the gains to offset leveraged loan writedowns. And it took an analyst’s question to force Bank of America to admit that $2.2 billion of its first-quarter 2009 revenue came from gains on Merrill Lynch debt. Moreover, banks like Citigroup and UBS include fair value gains and losses in the results of their investment banking arms, while the likes of Credit Suisse and HSBC keep the fluctuations out of divisional reporting.

Banks say they have little influence over the fluctuations, though Goldman Sachs seems to be one of the few that has minimized the effect with hedges. And Europe, at least, is phasing out the accounting rule in 2013. But inconsistent reporting makes it harder to filter out the noise. At a time when investors’ confidence is lower than ever, that’s something banks can do without.