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from MacroScope:

Euro zone may struggle with its own Lost Decade

Additional Reporting by Andy Bruce and polling by Rahul Karunakar and Sumanta Dey.

As Europe’s crisis drags on, the prospect of a Japanese-style lost decade of economic malaise is becoming increasingly real, according to a new poll. Half of the bond strategists and economists surveyed by Reuters are now expecting just such an outcome.

Many market participants have dismissed the fall of two-year German bond yields below their Japanese counterparts as being merely a result of a crisis-fueled flight to quality bid. Two-year German yields are now close to zero, offering returns of only 0.02 percent. By contrast, equivalent Japanese bonds are yielding 0.11 percent.

But a significant portion of analysts in a Reuters poll see something more sinister in the rapid narrowing of the premium investors require to hold German debt over Japanese bonds. One half of those polled – 12 out of 24 – said it is likely the euro zone is close to entering a period of prolonged low or no growth and inflation and low interest rates, with the other half saying it was unlikely.

According to Stephen Lewis, chief economist at Monument Securities:

I don't really see an early end to the financial crisis in the euro zone. I think it's very unlikely that Germany and the other countries will see eye to eye in the course of this year. That's going to keep the euro zone economy looking very weak for the next several quarters.

Europe's economy stagnated in the first quarter of 2012 and is expected to shrink 0.4 percent this year, according to another recent Reuters poll. Data on Thursday certainly pointed in that direction, suggesting even wealthier countries like France and Germany are also starting to feel the pinch.

from Breakingviews:

Summit silence on Greece is best option for now

By Pierre Briançon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

For once euro zone leaders did the right thing, the very thing they have been unable to do throughout the euro crisis: shut up. Their nine-line communiqué to say nothing on the subject was the only sensible option after their informal dinner Wednesday night. The other alternatives would only have made things worse. And whatever the pundits’ or markets’ expectations may be, it’s better for the euro summiteers to keep mum than to pretend having the answer which only the Greeks can provide.

Greece’s euro partners would like the second Parliamentary election, to be held on June 17, to become a de facto referendum on membership of the single currency. But they can’t insist too much without appearing to interfere in the Greek electoral process. The zone’s leaders are most probably ready to offer some concessions on the bailout programme to show that the euro is not just about pain and punishment. But they can’t reveal their hands before the election, because the radical parties rejecting austerity might feel emboldened and demand more concessions ahead of the vote.

Meanwhile, euro zone leaders and the European Central Bank must brace for the worst-case scenario of a Greek chaotic euro exit. But they can’t publicly admit that they’re planning for it, because it could amount to a self-fulfilling prophecy, and because markets turn south every time a European official simply mentions the possibility of Greece leaving the monetary union.

So what’s to do? Keep calm and carry on planning for the day after the Greek election - which, as it happens, will be the first day of the G20 leaders’ summit in Mexico. That may be difficult in a 17-country glass house and a 24-hour news cycle. But euro zone leaders must prepare plans for either dropping Greece, or supporting it with a plan to boost growth in an aggressive way. Strains in Spain, or Italy, might force them to the podium. But silence, in the next three weeks, will be golden.

from Breakingviews:

Italy’s new off balance sheet wheeze

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Rome is in a bind. Arrears to local companies are choking the economy, but funding them upfront could push up the country’s debt and spook markets. So Italy is using banks to front some of the money in a way that avoids pushing up its debt at least for the time being.

Rome’s unpaid bills by local authorities and other government entities to private suppliers are estimated at about 70 billion euros, or 4 percent of GDP. Euro zone accounting rules allow governments to exclude commercial arrears from their public debt levels until they are paid. But accumulating arrears hurts the economy, and a European directive next year will force governments to recognise unpaid bills. Spain has started to bite the bullet; it recently recognised 35 billion euros of arrears owed by its regions as debt, and is taking out a loan to pay them off.

Italy has just announced a plan to clear up to 30 billion euros of arrears by year end - but in a way that won’t affect its reported debt levels. Some of the arrears will be netted off against unpaid taxes that the suppliers owe. A further 6 billion euros was set aside to clear arrears in last year’s austerity package.

To handle the remaining chunk, Rome has come up with an elaborate piece of financial engineering. Italian banks will lend to suppliers once they have obtained a certification to prove that the payments are legitimate. The loans leave the bank exposed to credit risk. But a separate central government-backed fund will provide banks with guarantees. Those, in turn, will cut the risk weighting on the loans so enabling banks to offer suppliers better terms. As these guarantees are contingent liabilities, they too should stay off the government’s balance sheet unless called on.

This jiggery-pokery is a stop-gap solution. At some point the government will still need to pay the bills. And going through the banks may be less speedy than the government just paying the supplier directly. Still, with debt equivalent to 120 percent of GDP and markets febrile from the Greek crisis, it easy to see why Rome prefers keeping things off-balance sheet.

from Breakingviews:

Eurovision a good metaphor for lack of euro vision

By George Hay

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

The euro zone crisis is everywhere. The political and economic plight of Greece and Spain has reached fever pitch. And now awareness of the splintering currency area’s economic realities has reached the Eurovision Song Contest.

This annual musical cacophony, which dates back to 1956, features execrable europop sung by a succession of bizarre d-list pop stars who have somehow been deemed representative of their national culture. Voting takes ages and is conducted by hapless TV anchors of the host nation beaming live to all 26 participating countries in turn. In terms of efficiency, it has a lot in common with the actual euro zone.

This year it’s hard to resist hunting for subliminal messages in each nation’s songs. Part of the sober Finns’ entry translates as “Close Your Eyes”, summing up what most taxpayers in Helsinki want to do at the thought of fiscal transfers to the indebted periphery. On the other hand, Slovakia’s entry underlines the difficulty of getting all 17 members to reach a consensus: it’s called “Don’t close your eyes”.

Other entries are even more revealing. The Spanish have submitted “Stay with Me”, a transparent plea to German chancellor Angela Merkel to not abandon them. Germany’s own effort sums up its ponderous approach to the crisis. It’s called “Standing Still”.

But one entry actually addresses the crisis directly - and that country isn’t even in the euro zone. Montenegro’s song, “Euro Neuro”, is three minutes and five seconds of ostensible gibberish rapped by a middle-aged Montenegrin who goes by the unlikely name of Rambo Amadeus. But it contains a compelling message.

from MacroScope:

Greek political poll tracker

Greece faces another election on June 17.  Although they reject the austerity required by the bailout, most Greeks want their country to stay in the euro. However Frankfurt and Brussels say it is impossible for Greece to have one without the other: no bailout means no euro and a return to the drachma. Whether the Greek people believe these warnings could have a big impact on the election result.

First place comes with an automatic bonus of 50 seats, meaning even the slightest edge could be pivotal in determining the makeup of the next government.

Click here for an interactive chart showing the latest polls:

from Breakingviews:

Direct bank recaps won’t give Spain quick fix

By Neil Unmack and Fiona Maharg-Bravo

The authors are Reuters Breakingviews columnists. The opinions expressed are their own

If Greece quits the euro, Spain’s banks will be the next weak link in the single currency. Hence, the frantic search for ways to prop them up. One solution, advocated in recent days by France’s president and Ireland’s central bank governor among others, involves the direct injection of capital by a euro zone fund into Spain’s lenders. The appeal is obvious: Spain’s banks would be recapitalised but Madrid’s own debts wouldn’t rise. The country would therefore avoid the fate of Ireland which was dragged down by bailing out its lenders - even though its financial system is proportionately a lot smaller.

But there are complex political and technical hurdles that would have to be jumped before such a solution could work. As a result, direct recapitalisation of Spain’s banks, bypassing the sovereign, doesn’t look like a quick fix.

At the moment, neither the European Financial Stability Facility (EFSF) nor the soon-to-be-created European Stabilisation Mechanism (ESM) are able to recapitalise banks directly. Although the treaty setting up the ESM is moderately flexible, such a move would almost certainly require approval by at least Germany’s parliament. Given that direct recaps would require a potentially vast transfer of risk from peripheral countries to taxpayers in the core, that wouldn’t be easy. If Spain got such a good deal, other countries such as Ireland would want one too.

Before taking on such risks, taxpayers in northern Europe would demand far greater oversight of domestic banks, transferring power away from national regulators. They may also insist on “bailing in” bank bondholders as a way of mitigating their risk. None of this would be trivial for Madrid to concede not least because many bondholders are retail savers. Haircutting them would be politically problematic.

These obstacles may be overcome with time. The European Commission is, for example, already working on a continent-wide scheme for bailing in bondholders if banks get into trouble. But it’s unlikely that everything can be nailed down in time to help Spain manage a Greek exit. The main option would then be for the EFSF to lend money to Spain which, in turn, would recapitalise its banks. If a fix is needed fast, Madrid may just have to put up with a higher debt load.

from Global Investing:

Quiet CDS creep highlights China risk

As credit default swaps (CDS) for many euro zone sovereigns have zoomed to ever new record highs this year, Chinese CDS too have been quietly creeping higher. Five-year CDS are around 135 bps today, meaning it costs $135,000 a year to insure exposure to $10 million of Chinese risk over a five-year period. According to this graphic from data provider Markit, they are up almost 45 basis points in the past six weeks.  In fact they are double the levels seen a year ago.

That looks modest given some of the numbers in Europe. But worries over China, while not in

the same league as for the euro zone, are clearly growing, as many fear that the real scale of indebtedness and bad loans in the economy could be higher than anyone knows.  Above all, investors have been fretting about a possible hard landing for the economy, with the government unable to control  a growth slowdown.

The CDS rises have coincided with worsening economic data -- state-owned companies' profits have fallen 8.6 percent in the January-April period from year-ago levels while industrial production weakened sharply in April. Fixed asset investment - a key driver of the economy - has hit its lowest level in nearly a decade.

CDS fell slightly today after Premier Wen Jiabao called for more efforts to support growth. His comments also provided a mild boost to China's stock markets.  Gavan Nolan, Markit's director for credit research, says Wen's comments suggest growth is taking precedence over inflation in policymakers' minds:

from Hugo Dixon:

What is the long-term euro vision?

What should be the long-term vision for the euro zone? The standard answer is fully-fledged fiscal, banking and political union. Many euro zone politicians advocate it. So do those on the outside such as David Cameron, Britain’s prime minister, who last week called on the zone to “make up or break up”.

The crisis has demonstrated that the current system doesn’t work. But a headlong dive into a United States of Europe would be bad politics and bad economics. An alternative, more attractive vision is to maintain the maximum degree of national sovereignty consistent with a single currency. This is possible provided there are liquidity backstops for solvent governments and banks; debt restructuring for insolvent ones; and flexibility for all.

Enthusiasts say greater union won’t just prevent future crises - it will help solve the current one. The key proposals are for governments to guarantee each other’s bonds through so-called euro zone bonds and to be prepared to bail out each other’s banks. In return for the mutual support, each government and all the banks would submit to strong centralised discipline.

But the European people are not remotely ready for such steps. Anti-euro sentiment is on the rise, to judge by strong poll showings by the likes of France’s Marine Le Pen and Italy’s Beppe Grillo. Germany’s insistence last December on a fiscal discipline treaty has stoked that sentiment.

An attempt by the region’s elite to force the pace of integration with even more ambitious plans could easily backfire with voters, particularly in northern Europe. They would fear being required to fund permanent bail outs for feckless southerners. Premature integration might not even help with the current crisis if it backfired with investors. They might start to question the creditworthiness of a Germany if it had to shoulder the entire region’s debts.

In contrast, the principle of “subsidiarity” - the Maastricht treaty’s specification that decisions should be taken at the lowest possible level of government that is competent to handle them – is good politics and good economics. Of course, even advocates of political union such as Wolfgang Schaeuble, Germany’s finance minister, subscribe to this principle. The issue is to define the minimum conditions needed for the sustainability of the single currency. There are probably three.

The first is that insolvent entities - whether they are governments or banks - should have their debts restructured. One of the main reasons states and lenders were allowed to leverage themselves so much in the boom was because there was a widespread view that they couldn’t go bust. The complacency sowed the seeds of the crisis.

from Unstructured Finance:

UF Weekend Reads

The latest offerings by our Sam Forgione include a little Bridgewater, PIMCO and Jamie.

From National Journal:

Jim Tankersley airs Nick Hanauer's championing of the middle class after Hanauer's TED Talk was pulled.

From Barron's:

Ray Dalio explains why macro efforts to support the U.S. economy are "beautiful" in Sandra Ward's interview.

From The New York Times:

Alexis Tsipras has much to prove as one of Greece's top politicians.

from Breakingviews:

Cyprus’ bank bailout may not be the last

By George Hay

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Is nomen omen? Last month Cyprus appointed an economist called Panicos Demetriades as central bank governor. On Friday, the euro zone minnow committed to pump 1.8 billion euros, or 10 percent of GDP, into Cyprus Popular Bank (CPB) if its second largest lender can’t raise it privately. What’s more, this may just be a holding operation. If Greece quits the euro, Cypriot banks and the state itself will need more help.

CPB’s immediate capital deficit stems from the stress test conducted last December by the European Banking Authority, which left it needing to find 2 billion euros by the end of June. Given that its market capitalisation is now only 211 million euros, don’t count on shareholders lending a hand.

The good news for Cyprus is that CPB’s slightly larger peer Bank of Cyprus is only 200 million euros away from hitting its own 1.6 billion euro EBA target, following a rights issue. The bad news is that just sorting out CPB alone will put a serious dent in the country’s finances. If all 1.8 billion euros is used, the state’s debt would rise from 72 percent of GDP to 82 percent.

And looming over everything is what’s happening in Greece. Bank of Cyprus and CPB each have about 10 billion euros of Greek loans, of which already 13 percent and 19 percent respectively are non-performing. In the event of a Greek exit from the euro, they would both need further capital. Although the central bank’s data from the end of March doesn’t show any deposit flight, the lenders might also require help on liquidity.

Even without a Greek exit, the government’s finances are stretched. Last year it had a 6.3 percent budget deficit and received a 2.5 billion euro loan from Russia, with which it has close financial ties. The IMF thinks the economy will shrink 1 percent this year. In the long run, offshore oil deposits may provide some salvation. But if Athens brings back the drachma, Nicosia will be hard-pressed to avoid its own bailout from the euro zone.