July 28th, 2009

Europe borrows from Peter to lend to Peter

Posted by: James Saft

jamessaft1(James Saft is a Reuters columnist. The opinions expressed are his own)

Europe’s experiment in borrowing from Peter to pay Peter argues for a slow economic recovery with a low ceiling.

Data released by the European Central Bank on Monday showed that the supply in money is growing at best haltingly and that loan growth to euro zone households and businesses is at its lowest since records began.

Annual loan growth to the private sector slowed to 1.5 percent in June from 1.8 percent in May while the broader measure of money supply growth hit 3.5 percent.

Loans to non-financial corporations grew at a 2.8 percent annual rate, and actually fell from May. Household lending wasn’t that peppy either, with the growth rate falling to a paltry 0.7 percent annual rate.

Banks in Europe aren’t lending to consumers and businesses for a really sound set of fundamental reasons — borrowers know they ought not to be borrowing and the banks know that, of those who are asking for money, a disturbing minority can’t be trusted.

Demand is poor in other words and what demand their is has been skewed to the feckless end of the spectrum.

But there is one area of the market where both supply and demand seem to be growing healthily, or if you prefer, strongly: loans to governments.

There was an absolute surge in banks assets in June, with government bond purchases by banks up 53 billion euros, a 16 percent annual growth rate, and outright loans to governments up 19 billion euros, up 2.5 percent year on year. Financial institution holdings of government debt has risen by 271 billion euros in the year to June.

“This increase represents 3.0 percent of GDP and is thereby financing roughly half of the net general government borrowing requirement,” according to Julian Callow at Barclays Capital in London.

And this credit is from the same banks which borrowed 442 billion euros last month for a whole year at a fixed interest rate of 1.0 percent. At the same time overnight deposits at the European Central Bank rose yet again to 195 billion euros, further indicating that funds are not making it into the private economy.

Europe’s banks are borrowing from Peter to lend to Peter.

PECULIAR ARRANGEMENTS

The circularity of it all is admirable. Banks in Europe borrow at very low rates from the European Central Bank. At least to judge by the data, much of the money is ending up in government bonds. This government debt is being issued, at least in part, to fund banking bailouts. Everybody is happy right?

Of course there are some substantial ancillary benefits: banks themselves will make handsome, low risk money by collecting the difference between the cheap financing they get from one arm of government and the slightly more expensive rate they collect from Europe’s governments for holding their bonds.

This rebuilds a capital base that has been sorely eroded by higher risk lending, but it is a slow process. It also does very little to encourage better banking practices for the next cycle. It does not take a genius to borrow from one arm of government and make a float lending to another, and as such we can’t really say that Europe’s banks are going to have their weakest members thinned out.

What it does do is make government borrowing cheaper than it would otherwise be, which on balance is no bad thing. Given the difficulties some of the weaker euro zone governments were facing earlier in the year, a captive, or at least pliant, class of government bond buyers is a useful counterbalance to the more flighty behavior of people who can’t borrow money directly from the ECB.

A lot of lending to banks, and lending and spending by governments can help ease a recession but its unclear if it can be the basis of a strong recovery.

Politicians, inside and outside of the euro zone, are fond of leaning on banks to lend to the real economy in greater amounts at easier rates.

British Treasury Minister Alistair Darling met with bank chiefs on Monday to urge them to lend more to small businesses, a type of photo opportunity we may be seeing more of as the recovery drags on and growth fails to ignite.

It is good theater but it does little to address the underlying issues of poor prospects for corporate investment and the economy-wide need to retire or destroy debt.

If things work out well it is just possible that in a year or so good business with good prospects will have real complaints about not being able to get adequate funding.

At that point we will see if the borrowing from Peter to lend to Peter arrangement has worked or if it will prove to be a too slow and too indiscriminate way of healing the banking system.

( At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

January 16th, 2009

Betting on the unthinkable in the euro zone

Posted by: James Saft

James Saft Great Debate — James Saft is a Reuters columnist. The opinions expressed are his own –

Some crises bring partners closer together. Some, as investors in the euro zone are likely to discover this year, drive them further apart.

Look for rising tensions about fiscal and monetary policy among the bloc’s 16 member nations, and for a bigger penalty to be imposed on the euro and some euro zone assets against the possibility of a breakup or a secession from the currency group.

The liquidity crisis of last year left smaller members of the euro thanking their lucky stars they were inside a big warm tent with a major currency and critically, a powerful central bank that could help banks and maintain order in financial markets.

Ireland and Greece, to name but two, could look at the disaster in Iceland, which suffered a banking and currency collapse, and see the real tangible benefits of membership.

But now that the crisis has morphed into one in the real economy, with exports plunging and employment hit, things will be less cohesive within the euro zone, with one currency having to do duty for different countries with different economies and levels of competitiveness.

European governments vary widely in their ability to withstand the fiscal squeeze from falling tax receipts, as well as having varying ability to credibly take on programs of stimulative deficit spending. That of course is about all that euro countries have open to them when it comes to unilateral action, being forced as a condition of membership to live with a common currency and interest rate policy.

The ECB is widely expected to cut rates by a half a percentage point on Thursday, to 2.0 percent, a level considerably higher than the ideal for many hard hit smaller economies.

The implication is weakness for the euro, as investors impose a breakup premia, and more weakness for the bonds of smaller peripheral countries.

Standard & Poor’s on Wednesday cut Greece’s sovereign debt rating, citing falling competitiveness and a rising fiscal deficit. S&P has also threatened the credit ratings of Ireland, Portugal and Spain on concerns about deteriorating public finances.

The extra interest Greece must pay to borrow money for 10 years as compared with Germany stands at 246 basis points, while for Ireland the figure hit 180 basis points, also a record, and spreads have widened too for Spain and Portugal. Coming at a time of low interest rates, with German 10-year debt yielding just over 3 percent, these are whopping premiums for debt that theoretically should be very tightly related.

CHEER UP, IT MIGHT NEVER HAPPEN
To be clear, the chances of a country leaving the euro zone currency project are still extremely small, though it now rates as a possibility for discussion in polite company.

For one thing there is no escape hatch, no plan as to how a national currency might be reborn. For another, there is the matter that while a bit of a weak currency and an accommodative interest rate might seem attractive at first blush, the reality would include much higher interest rates and the real risk of a Latin-American style inflation and currency crisis.

“Put very simply if either Greece or Italy, for example, left, the sort of spreads they are trading on at the moment would have to treble,” said Marc Ostwald, strategist at brokerage Monument Securities in London.

“There would be colossal inflation in both countries as a result.”

It would also be extremely tricky to pull out without very seriously impairing your national banking system, though that impairment may come of its own momentum anyway, conceivably as the flash point for a break-up. But just because something is a dumb idea doesn’t mean it won’t be advanced as reasonable.

There are other issues causing problems for countries with smaller bond markets. Investors are generally showing an almost unprecedented preference for stuff that is easy to sell, and German bonds are just a lot more liquid.

You can also argue that the kinds of very narrow spreads we saw before the crisis were simply one more manifestation of the headlong search for yield, and that some but not all of the re-pricing is warranted as a reflection of the new reality.

There are a couple of bitter ironies here for the euro zone. The world has probably never needed an alternative reserve currency more, with natural demand likely to rise for liquid, safe non-dollar assets given U.S. imbalances and monetary policy experiments.

It is also a bit raw that the downturn that will test the euro zone is not of its making. Its consumers by and large didn’t gorge at the debt feast and savings rates remained on the whole higher.

But that is cold comfort and no assurance the price of the risks of euro disintegration won’t rise further.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.