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from MacroScope:

Shifting euro zone sands

A telling moment. Before pretty much every showdown EU summit since the debt crisis exploded into life, the leaders of France and Germany have got together beforehand to agree a common strategy. It is a truism that the European motor only works efficiently when its two biggest powers are in accord.

This time, following the election of Francois Hollande as French president, there has been no such meeting. Instead he will talk with Spanish premier Mariano Rajoy in Paris before they head to the Brussels summit. There, Hollande will press for the currency bloc to start issuing joint euro zone bonds and will run into implacable German opposition that will squash the plan for now. But the plates are shifting and German Chancellor Angela Merkel looks somewhat isolated.

On euro bonds, Hollande can call on the support of Italy’s Mario Monti and the European Commission among others. Nonetheless, Angela holds the purse strings so while we will see some modest pro-growth measures agreed (and no doubt trumpeted), there will be no pump-priming that requires extra deficit spending, certainly no mutualising of debt and probably no hint that the likes of Greece and Spain will be given longer to make the cuts demanded of them (though that policy's time could soon come, depending on how the June 17 Greek elections go).

Greek contagion aside, Spain remains the bloc’s biggest headache largely because of the weight of bad debts dragging its banking sector down. One idea is to allow the euro zone’s rescue funds to lend to banks direct, thereby removing the stigma of a government having to ask for aid. But Berlin is not keen on this one either.

Less controversial are plans to boost the capital of the European Investment Bank, use “project bonds” backed by the EU budget to invest in infrastructure and recalibrate some EU structural funds which has been used to help poorer EU members so that it is spent in other areas which might yield a quick growth dividend. None of that can hurt. But peashooters and elephants come to mind.

The golden rule of this crisis is that red lines have and will be crossed, most notably by Germany and the ECB, if the bloc is teetering right on the edge. The first ones to give this time may be on relaxing debt-cutting timeframes and allowing the bailout funds to help banks direct. Euro zone bonds remain a long way off (probably only when all member countries have got their deficits sustainably below 3 percent of GDP) and talk of a bloc-wide bank deposit guarantee fund isn’t anywhere near, though the pace of events could change that. Much hangs on how Greeks vote on June 17.

A demonstration of just how bent out of shape the euro zone is will be provided by today’s German 2-year debt auction. Yielding about 0.07 percent on the secondary market, that means Berlin has set a zero coupon for this sale and will pay no more to borrow this money over two years, yet investors are still expected to snap it up, such is the desperation for something secure. The debt agency says it is not planning to start offering negative coupons.

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 MacroScope:

All eyes on Wednesday EU summit

After last week’s hefty losses, European stock gained yesterday and are up up again this morning, denoting some optimism about the Wednesday supper summit of EU leaders, which might well be unrealistic.

The European growth measures that we know are in the works – boosting the paid-in capital of the European Investment Bank and plans for 'project bonds' underwritten by the EU budget to finance infrastructure – might help a little but will fall a long way short of turning the euro zone economy around, so unless we get something more, on either the growth or the building defences fronts, there’s scope for investor disappointment.

Europe’s international partners continue to demand more dramatic crisis action. After the G8 summit, President Obama was out last night with four demands: - firewalls to protect countries from Greek contagion (are the ESM and IMF funds now viewed as insufficient?), - recapitalization of banks that need it (Spain to the fore here presumably), - A growth strategy to run alongside tight fiscal measures (easier said than done), - easy monetary policy to help the likes of Italy and Spain keep cutting debt (the ECB thinks its 1 percent rate is very loose and is unlikely to cut soon with inflation above target and will only flood the system with more liquidity in utter extremis)

Nothing new there but it keeps up the drumbeat of pressure ahead of the EU get-together. We know French President Francois Hollande, with the backing of others, will press the case for common euro zone bonds at the summit and also know that German opposition will not weaken one jot on that score. Spain’s Rajoy is pressing for more ECB involvement, presumably by reviving its bond-buying programme. Given internal opposition to that within the ECB that is probably the least likely measure to be reactivated, yet anyway.

Despite money flowing out of Greek banks, and at least the threat of it spreading more widely if Greece bombed out of the euro zone, there is no hint yet of any planning for any scheme to underwrite bank deposits across the bloc, probably because the ECB and Germany will not countenance underwriting it. The golden rule of this crisis is that red lines have and will be crossed when it reaches breaking point. We’re not there yet.

With so much focus on Greece and Spain, Portugal has been somewhat overlooked in recent weeks but it will quite likely need a second bailout at some stage and if Greece prompts a wave of contagion, it will be firmly and instantly in the firing line.

from MacroScope:

Merkel under pressure … but unbending

Some interesting events to  ponder over the weekend, though not many of them came from the G8 summit which, as is customary, was strong on rhetoric but bare of any specific policy measures to tackle the euro zone crisis. However, markets seems to have tired of their panicky last few sessions. German Bund futures have opened lower as investors took profits rather than seizing on any positive news. European stocks have edged up.

It does appear that with the ascension of France's Francois Hollande, the G8 firmament turned into G7 (or maybe 5 since we didn’t hear much from Japan and Russia) versus 1 (Germany) but as things stand we’re still heading for a fairly anaemic “growth strategy” unless euro zone leaders coalesce behind the notion of giving Spain and Greece longer to make the cuts demanded of them. Spain has moved the goalposts further in the wrong direction, revising its 2011 deficit up to 8.9 percent from 8.5 and blaming the overspending regions. That means its already loosened target of 5.3 percent for this year is now even harder to achieve.

Hollande is talking up the case for common euro zone bonds but that will not wash with Berlin for a long time yet. Sources said Monti used the G8 forum to promote a pan-European bank deposit guarantee fund. Good idea but that too will only be conceivable if the European financial sector is on the point of toppling. And who will underwrite it? There is talk too of allowing the EFSF to lend direct to banks to ease the Spanish government’s reluctance to ask for help. That may have a slightly better chance of success but Berlin doesn’t like this idea either. Look no further than the German Chancellor’s take on the summit – it was all a great success, she said. Everyone agreed that we need both growth and fiscal consolidation.

Angela Merkel is one the one with her hand on the purse strings and she knows the markets will only allow so much fiscal loosening. However, the hefty 4.3 percent pay rise secured by Germany’s most powerful union, IG Metall could be a sign that Berlin is starting to loosen the edges of its anti-inflation culture in order to foster a bit of domestic demand. Any profound return to euro zone growth is going to require some internal imbalancing – and that means Germany buying more from its partners to allow them to export more.

No one can accuse Merkel of being disengaged. Despite denials from Berlin, it seems she may have suggested to the Greek president that a referendum on euro membership should be held in parallel with the June 17 elections, a pretty astonishing intervention in another country’s democratic process.

It is certainly true that the mainstream, pro-bailout Greek parties’ only chance of doing better this time is to turn the election into a “euro in or out” poll by explaining why abandoning the bailout will open the exit door. But they have a lot of work to do to regain credibility. Of a series of opinion polls over the weekend, two put the anti-bailout SYRIZA ahead and another gave pro-bailout New Democracy the lead. Since the party who comes in first gets an extra 50 parliamentary seats, the tightness of the race is going to have markets on tenterhooks for the next four weeks. We had a nicely timed interview with SYRIZA leader Alexis Tsipras which ran overnight. He meets French leftist Melenchon today and is talking about building relationships and forging negotiations so Greece can stay in the euro. However, he will not be meeting government officials in France and said the terms of Greece’s 130 billion euros bailout were now a “dead letter” and noted what he saw as the changing dynamics at the G8.

In the meantime, Greeks continue to withdraw their money from the banks, a trend which if it reaches critical mass, could force a European policy response even before the election. If that starts taking root elsewhere, the whole system will be creaking. Spanish banks’ bad loans have hit their highest in 18 years and, with so much tied into a bankrupt property market, no one is quite sure how much worse it is going to get. Late on Friday, clearing house LCH.Clearnet raised the cost of using Spanish bonds to raise funds.

from Breakingviews:

Botched bailout rebounds on Bankia

By Fiona Maharg-Bravo

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

Bank nationalisations are never pretty, but they are generally supposed to reassure savers. That’s why a report that depositors fled Bankia after the government last week took control of Spain’s fourth-largest lender is so troubling. The government has denied the report, and Bankia’s new chairman said depositors can be absolutely calm. Yet the latest share price plunge inflicts further pain on clients who participated in the lender’s IPO last summer.

To be fair, recent nationalisations of Spanish banks, such as Caja del Mediterraneo or Cajasur, have led to some deposits shifting to competitors. And even if the reports about Bankia losing 1 billion euros of deposits were correct, that’s still less than 0.6 percent of the bank’s deposit base. However, given the crisis in Greece and worries about contagion to the rest of the euro zone, it’s understandable that investors are particularly sensitive to any signs of capital flight in other countries.

Yet if some Bankia clients have turned their backs on the bank, this is more likely to be as a result of the bank’s plunging share price than a lack of confidence in Spain’s government to protect their deposits. Many retail customers who bought shares in Bankia’s initial public offering last July have lost 60 percent of their investment - a fall that was exacerbated by the government’s decision to take control of BFA, Bankia’s parent company. Despite various leaks, the state has yet to detail how it plans to recapitalise the bank.

The unhappiness seems to be concentrated on Bankia, which suggests that clients who do defect will move their money to other Spanish banks. The government and Bankia’s new management team could clear the uncertainty by spelling out their plans as soon as possible. But it’s hard to see any plan that doesn’t lead to large-scale dilution of existing shareholders, raising the prospect of a vicious cycle. The government may be afraid to lean on them too heavily for fear of damaging the franchise. But given the steep fall in the share price, it may be a bit late for that.

from Global Investing:

Three snapshots for Tuesday

The euro zone just avoided recession in the first quarter of 2012 but the region's debt crisis sapped the life out of the French and Italian economies and widened a split with paymaster Germany.

Click here for an interactive map showing which European Union countries are in recession.

The technology sector has been leading the way in the S&P 500 in performance terms so far this year with energy stocks at the bottom of the list. Since the start of this quarter financials have seen the largest reverse in performance.

from Global Investing:

Three snapshots for Monday

The yield on 10-year  U.S. Treasuries, fell to their lowest levels since early October today, breaking decisively below 1.80 percent. That compares to the dividend yield on the S&P 500 of 2.28%.

The European Central Bank kept its government bond-buy programme in hibernation for the ninth week in a row last week. The ECB may come under pressure to act as  yields on Spanish 10-year government bonds rose further above 6% today.

Output at factories in the euro zone unexpectedly fell in March, the latest in a series of disappointing numbers signalling that the bloc's recession may not be as mild as policymakers hope. On an annual basis, factory output dived 2.2 percent in March, the fourth consecutive monthly slide, Eurostat said, and only Germany, Slovenia and Slovakia were able to post growth in the month.

from MacroScope:

Greek tragedy

Greece is stumbling inexorably towards fresh elections which polls suggest will give the anti-bailout far left a stronger grip on power. Last ditch talks aimed at creating a unity government will continue under the aegis of the president today but the leader of the radical leftist SYRIZA has said he will not turn up. Alexis Tsipras says he wants Greece to stay in the euro but will rip up the bailout agreement. Go figure. This morning the more moderate left party has said it won’t take part in a government lacking SYRIZA.

A big question is whether the mainstream parties can mount a convincing campaign second time around, playing on the glaring contradiction in SYRIZA’s position and essentially turning the vote into a referendum on euro membership, which the overwhelming majority of Greeks still support. Don’t count on that.

Two ECB policymakers --  Honohan and Coene – were out over the weekend talking about the possibility of a Greek euro exit: there goes another taboo. Policymakers must be running through the hard default and exit scenarios now. We need to be asking.

As we’ve said before, Greece has some leverage. The IMF, ECB and euro zone governments are holding a lot of Greek debt so have an incentive to keep the  show on the road or face heavy losses if there is a hard default. Of Greece’s 250 billion-plus euros of debt, nearly 200 billion is now held by those public bodies. It is also hard to see how Europe could avoid propping Greece up even if it did leave the currency club. The calculation for euro zone leaders is whether pouring good money after bad into Greece is more or less palatable than taking a big hit on their Greek debt holdings.

Greece will obviously loom large over this evening’s meeting of euro zone finance ministers in Brussels. But so will Spain. There is talk of Madrid getting some leeway on its deficit-cutting targets after the European Commission predicted on Friday they would be missed. But first it will have to present a more credible 3-4 year plan on how it will get there. So don’t expect anything definitive today. Spain is grappling with its bad bank debt problem but the 84 billion euros it has told banks to put aside still looks shy of what’s needed. Either government or euro zone money is likely to have to come to the rescue at some point. So far banks have responded with plans that do not require state aid, apart from Bankia which was essentially nationalized last week.

If Spain is cut some slack then why not Greece? (maybe because it has been bailed out twice). Venizelos, the finance minister who negotiated the second bailout, has suggested Athens gets three years instead of two to produce the cuts demanded in its loan programme. If that happened, Portugal and Ireland would presumably demand better terms for their bailouts but it’s not impossible – we’re clearly into policymaking directed at the lesser evil here.

A hefty defeat for Angela Merkel in a key state election on Sunday may not help her bend the rules to keep Greece going. But as regards a euro zone growth strategy -- a hot topic this week with Francois Hollande rushing to Berlin for a debut visit -- the fact the centre-left SPD, who have argued against austerity for austerity's stake, cleaned up in North Rhine-Westphalia is interesting. Another prominent growth proponent, Mario Monti, said on Sunday that Italy's social fabric is being torn by recession and tensions are growing among its citizens. It looks like there is a growing resolution that the end-June EU summit must come up with more profound growth measures than anything currently on offer. More time to meet deficit targets looks like the obvious option.

from MacroScope:

Risk of contagion if Greece exits euro: WestLB

What happens if Greece leaves the euro? No one can say for sure. But John Davies at WestLB, finds it difficult to envision a benign outcome.

Greece’s economy, at around $300 billion, is very small compared to the euro zone as a whole. The problem is if other countries follow suit – or are pressured in that direction by stubborn financial markets.

Such a scenario doesn't bear thinking about because it is so horrible.

There is a good chance that the market would immediately trade Portugal towards pre-debt swap Greece levels. The next in line would certainly be Ireland and Spain.

Initially you have got to assume that spreads would become even more dislocated. As you are moving out and down the credit curve the ones with the weakest credit ratings will likely suffer worst, at least initially, because we are moving clearly into the world of the unknown and that's precisely what the market doesn't like.

The Greek elections have left a political vacuum that is raising speculation that the country may eventually exit the euro. Last Sunday, Greek voters punished mainstream parties that supported harsh austerity in exchange for international bailout cash. That left the Greek parliament with a jumble of minority parties that have been unable to form a government.

The leaders of Greece's once-dominant conservative and socialist parties made a push on Friday to avert new elections and prevent a victory by a radical leftist who has promised to tear up its international bailout deal.

Inability to implement the reforms set out by international lenders amid this political void could compromise the country's life-support bailout money and lead to a default. This could make the country's membership of the euro increasingly unsustainable, even though those very reforms risked choking growth further in an economy suffering its fifth year of recession.

Even Germany, the key driver of growth in the euro zone, might eventually be threatened by worsening financial and economic conditions around it. And what of the bullish German Bund market which seems to know no bounds? Davies again:

from Breakingviews:

Euro zone carry trade has limited shelf life

By Neil Unmack and Fiona Maharg-Bravo

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

The carry trade is alive and well in Spain and Italy. Banks are loading up on sovereign debt, thanks to the wave of liquidity from the European Central Bank’s cheap three-year loans. But local lenders can’t fund Madrid and Rome indefinitely, and with markets still dysfunctional, money could run out sooner than expected.

Spanish and Italian banks borrowed 220 billion and 140 billion euros of new money, respectively, under the ECB’s cheap three-year facilities. So far, they have mainly used the cash to replace privately-held bonds that are falling due, or to buy government debt. Spanish banks have bought 85 billion euros of sovereign paper between December and April, while Italian lenders have propped up the state to the tune of 77 billion euros. That’s allowed the two countries to carry on borrowing when international investors are scarce.

In theory, this could carry on for a while. RBC estimates Spanish banks have 82 billion euros of ECB cash left over - double the 41 billion euros that Madrid still needs to raise this year. As some investors - particularly domestic ones - are likely to swap maturing government bonds for new ones, Spain may only need 20 billion euros of new money. Italian banks, meanwhile, have 53 billion euros of ECB firepower, according to RBC. If domestic investors play ball, the government’s funding gap this year is around 70 billion euros.

Moreover, despite their recent splurge, banks have room to increase their holdings. Sovereign bonds account for just 7 percent of total balance sheet assets in Spain and 7.8 percent in Italy. In 1999, the share in both countries was over 10 percent. In Japan, it’s 23 percent.

However, larger banks like Santander, BBVA and UniCredit are unlikely to increase their sovereign exposure. Smaller banks face less scrutiny from markets, but also have less spare liquidity. Besides, banks have more pressing needs: Spanish lenders must refinance about 65 billion euros of funding this year, and there’s little prospect of them being able to tap wholesale markets.