Prof. Enrico Colombatto (Turin), IREF scientific director, has provided his update on EU policies. This month, he describes sovereign bailouts, the probable change of monetary policies, and the repayment of ECB loans.
Domestic. How are the high profile struggling countries faring – Greece, Cyprus, Portugal, Ireland?
Despite the January media narrative that the worst of the crisis is over and the bailouts are working, the specific positions of the four countries challenge this position.
With a contribution of only 0.2% of the Eurozone’s GDP, Cyprus may be the smallest of the 17 Eurozone countries but, ironically, it may yet exert a disproportionate influence on the structure and culture of sovereign bailouts in the months to come.
On the first working day of 2013, President Christofias announced Cyprus’ response to the standard Troika (ECB, EU and IMF) bailout offer. Cyprus would like to receive the money, but preferred to decline the reciprocal obligation of selling state assets and raising its corporate tax rates to please the Troika; and it would want all its citizen stakeholders in banks to be protected.
Was this brinkmanship? Possibly not. It may turn out to be a clever poker play. The repeated position of the EU and ECB is that no country should be ‘let go’ or allowed to collapse financially. This of course invites moral hazard. Cyprus argues that its position is reasonable since its banking system is so heavily exposed to Greece that its problems are substantially the result of the haircuts twice imposed on Greek bondholders by the Troika in 2012. Cyprus had agreed to the Greek deals without asking for any special exemption for Cypriot banks.
The €10bn requested by Cypriot banks (of the €17.5 bn total package) equates to 50% of the country’s GDP, and it is hard to see the government’s obligations, absent forgiveness, fail to jump from 83% of GDP in June 2012 to a 150% ratio a year later. By mid month, government debt was trading at yields of 11 – 12%.
Furthermore, given that bank deposits equivalent to 130% of GDP belong to investors from Russia and Eastern Europe, a ‘standard’ full bailout of Cyprus’ banks might represent a step too far for Germany and the wealthier nations. Perhaps for this reason, at the time of writing the terms are still under discussion, with suggestions that haircuts may be imposed on depositors in excess of the €100,000 guaranteed ceiling. But if that were to happen, might it not destabilise some banks in supposedly stable countries by encouraging capital flight?
Ireland has received plaudits for the harshness of its austerity and its adherence to the terms of its November 2010 €85bn bailout. At the time, Dublin’s request to impose haircuts on senior bondholders was rebuffed by the ECB, who feared contagion. Ireland has not enjoyed Greek style forgiveness of nominal debt, and its quiet campaign to have its interest rate cut to the new Greek level was politely dismissed in June 2012. Irish government debt is now perilously close to the magical 120% of GDP level, and unemployment is at nearly 15%.
Even the IMF recognised in the latter half of January that the debt burden cannot be serviced by Ireland’s tax receipts, and called for direct ESM recapitalisation of banks.
At the time of writing we learn of the Irish Government’s decision, approved by the ECB, to liquidate two previously bailed out banks, Anglo Irish and Nationwide. This news is highly significant since it challenges axiomatic bailout fundamentals, and will be analysed in our March newsletter.
Greece announced further tax hikes mid month. Corporate tax rates increased from 20 to 26% and the top personal income tax rate was raised two points to 42%. There is increasing evidence that these sorts of measures have the opposite to the desired effect – in the 12 months to November 2012 the corporate tax take fell 40% and the rate of the economy’s shrinkage seems not to be slowing. On the positive side Athens has promised to cut public sector jobs. Numbers of up to 150,000 of the total 900,000 civil service (the total labour force amounts to 5 million people) have been mentioned, but there is scepticism as to actual intentions. Unemployment remains at 27%.
Portugal ’s successful sale of €2.5 bn 4 year bonds on January 23rd was seen as evidence of the country’s recovery from its May 2011 €78 bn bailout. Time will tell, but the ECB’s repo operations surely make the carry trade, buying Portuguese bonds yielding 4.9% and financing the purchase with cheap 0.75% funding from the ECB attractive? As for Portugal’s progress, the table below contains the annual deficit levels, (as a percentage of GDP) agreed as part of the bailout, and the outcomes:
2010 - Actual: 9.1%
2011 - Target: 5.9% - Actual: 5.9% or 6.7%*
2012 - Target: 5% - Actual: 5 or 6%*
2013 - Target: 3% revised to 4.5%
*The numbers are complicated in both cases. Commentators justify the different numbers; for example in 2011 there was a one-off transfer of banks’ pension funds to the state which accounts for the difference in the two numbers. Portuguese unemployment is over 16%.
The table highlights the reduction in the rate of growth of Portugal’s debt, but further progress is expected to be stressful.
Incoming Bank of England Governor Mark Carney has suggested that monetary policy should be focussed on boosting growth, not on curbing inflation. Leaving aside the presumptuousness of such comments prior to taking office, given that the Bank of England’s statutory obligation is to ensure that inflation remains within a target specified as 2% per annum, the comments were rightly regarded as significant.
Should Carney’s inclination garner support, the UK would move from inflation targeting and adopt nominal GDP (NGDP) targeting.
Proponents of nominal GDP targeting argue that it works better in price shock scenarios. For example, were there an oil price shock owing to supply restrictions, a central bank bound only by an inflation target must apply a policy that would artificially disinflate the price of other goods to compensate. It has also been argued that NGDP targeting spins better in the press, that ordinary folks would be happier if their central bank was seen as trying to boost ‘nominal income’ rather than drive up inflation if this stuttered below the 2% target.
However appealing these arguments may be internationally, in the UK inflation has been consistently above the 2% target for years, indeed many have claimed that the Bank of England has been blatantly ignoring its mandated target, despite its legal obligation to respect the target. In this regard, the UK inflation (CPI) target has become a Maastricht Treaty style rule, honoured more in the breach than in the observance.
Critics of NGDP targeting argue the following. If there is an NGDP target and the economy tanks, then the central bank has to aim for a higher inflation rate to achieve the NGDP target. This is viewed as a pretty soft target and a more relaxed accountability regime for the central bank.
By way of example, if the UK had had NGDP targeting throughout the last five years, with GDP growth of zero then the Bank of England would have been justified in delivering inflation of about 4% pa instead of being criticised.
We incline to the view that the increasing discussion of replacing inflation targeting with nominal growth targeting, not only in the UK, has been driven by central bankers who recognise their ability to control inflation is inconsistent with their mandate to “support” national banking systems. Support via bailouts generates inflation. But this form of support cannot be withdrawn, and therefore it is better to change the target; it allows central banks to carry on doing what they cannot stop doing. One wonders whether anybody ever looks further than the ends of their noses.
What should we make of the news that several banks have been reported to be repaying their ECB loans? The ECB has reported repayments of over €130bn by the start of February from over 270 banks. The loans being repaid are largely from the 3 year “Long Term Refinancing Operation” €1tn funding facility that was made available to the banks at an interest rate of 1% pa for 3 years.
Unsurprisingly, news of the repayments has been presented as good news, evidence that the worst of the crisis is over. Is it? Let’s consider the scale of the repayment first.
In the last week of January the ECB’s balance sheet fell €13.4 bn to €2.93 tn. This is the latest in a series of reductive steps – the balance sheet peaked at €3.1 in mid 2012, or an overall drop of just over 5%. In contrast, the Federal Reserve’s balance sheet has grown by 5% and the Bank of England’s by 10% over the same time frame.
Why have the banks repaid LTRO funds?
When the LTRO scheme was set up, pressure was put on a large range of banks to participate. National central banks and regulators were worried that if the facilities were not widely used by all their major banks, then a stigma would attach to those that did use it. There was an even greater fear that, since everyone involved was thinking along these lines, in such circumstances the banks that really were short of liquidity would be tempted not to take the funding for fear of being identified with the stigma.
Another factor behind the banks’ decisions must be the impact of the Draghi promise (July 26th 2012) to do “whatever it takes” to save the euro. This promise has been believed and we have no doubt that markets are right to believe it. The speech has achieved the desired result, unlimited QE and bond buying would have been unleashed if sovereign bond yields reached levels the ECB deemed unacceptable.
Along similar lines to the Draghi promise have been the considerable efforts of national governments to increase bank lending through subsidies, such as the UK’s Funding For Lending scheme. The existence of this has relaxed UK banks’ need for RMBS securitisations, with the result that credit spreads for such securitisations have fallen by about 40 bppa over the last year.
Consequently, although it would be a stretch to say that markets for bank funding have turned a corner, the environment today is certainly less aggressively hostile than it was a year ago.
By way of detail, it is notable that two Portuguese banks (BCP and Espirito Santo) have stated that they have repaid ECB funding since markets are more open to them. The Portuguese banks are known to have particularly weak balance sheets, heavily laden with defaulted housing loans. We wish to cast no aspersions, but reality is clear, banks have no incentive to warn creditors about possible problems. None of the major recent banking shocks have been preceded by warnings – SNS Reaal in the Netherlands surprised markets, just as that country’s Dexia did in October 2011 having been passed as ‘safe’ under supposedly extreme stress tests by the European Banking Authority that July.
In conclusion, clearly we would grant that access to liquidity sources other than the ECB for many banks has improved. The Draghi promise/ threat has shaken out some bears.
However, the macro economic position also has a bearing on bank repayment decisions. With the growing levels of unemployment, miserly economic growth (Eurozone GDP is only 2% above pre-crisis levels, the US is up by 7%), and reduced consumer and business confidence, the main factor behind the repayments may simply be that banks have no profitable use for the funds. Why pay 1% per annum for funding when the best option is to redeposit it with the ECB at a rate of zero?