IREF - Institute for Research in Economic and Fiscal issues
Fiscal competition and economic freedom
This 3rd newsletter, written by Kevin Dowd and Gordon Kerr with Enrico Colombatto, is pointing out the auterity consensus tested as the Irish liquidation of Irish Bank Resolution Company, anayzing also further Collapses, Poor Results and Regulatory Arbitrage in banking.
Domestic Policymaking – The Austerity Consensus Tested
Europe’s policymaking elite were optimistic in January about the currency bloc’s prospects, citing receding fears about the collapse of the common currency, and reductions in both current account deficits and yields on bonds of some of the most indebted member states, plus a mild improvement in European stock markets. Ireland and Portugal even managed to return to the bond markets.
February’s events highlighted the looseness of the Eurozone’s collective efforts and crisis abatement. January’s optimism appeared confined to an ever shrinking policy elite. The underlying economic forces implying a future bifurcation of the paths of northern and southern countries strengthened.
The most important events were political. The collapse of Slovenia’s government , whose outgoing prime minister faces allegations of tax fraud, and of Boyko Borisov’s Bulgarian administration, who appear to have allowed a Czech energy supplier to profiteer by nakedly hiking prices, ruffled the calm, but were later dwarfed in significance by events in Italy.
In November, only 12 months after his appointment by the EC, Mario Monti had declared his austerity “mission accomplished”, a surprising boast given that he had cut little and simply increased taxes. Nonetheless Italy’s national debt is about 127% of GDP and growth is negative. Monti won only 10% of the Feb 25th vote. The 25% protest vote for Grillo’s 5 Star party highlighted public disdain for the main parties, with the traditional centre right (Berlusconi) and centre left (Bersani) coalitions each polling about 29%. Neither of these two main groupings appear committed to structural reforms—say , in the labour market and in the bureaucracy.
Markets reacted with apparent shock, the Italian 10 year bond yield rose by half a percentage point to 4.9%, and the euro fell 5 cents to $1.30.
From a broader perspective, the Eurozone economy continues to shrink. Data compiler Markit reported that manufacturing and service activity shrank faster in February than in January, and even the European Commission forecast a 0.3% contraction for 2013 and increases in unemployment, expected to average 12.2% across the zone.
What do we expect for the coming months? The difficulty of growing the eurozone’s disparate economies from excess credit fuelled levels is becoming more apparent. The difficulty of implementing austerity is increasingly obvious.
The next phase of the crisis may engulf larger countries. France, who only a year ago campaigned hard for the budgetary disciplines set out in the January 2012 Fiscal Compact, declaring them to be crucial to fixing the Eurozone, announced in February that it cannot meet its own deficit reduction target (down to 3%).
Germany is expected to push for federalisation via the hardening of fiscal compact rules, budgetary and banking supervision, whilst resisting calls for a debt union. We expect Germany and the EC to push for harder austerity, for fear that otherwise countries will have no incentive to reform their economies. This in turn will be even less popular with national electorates, and requests for bailouts are almost certain to increase, but the problem this time around is that requests are likely to come from countries whose debts are already above the supposedly critical level of 120% of GDP.
Central Banking – The Irish liquidation of Irish Bank Resolution Company
In early February news broke that IBRC was to be liquidated by the Irish Government, and also that Ireland had secured a favourable deal with the ECB on the terms of the legacy debt pertaining to this entity, which housed two of the most spectacular bank casualties – Anglo Irish’s losses having totalled 6 times its stated capital base.
The presently prevailing view among Irish commentators and politicians is that the 100% taxpayer guarantee of all creditors of IBRC was a mistake, but one they have to live with.
Whilst the Irish Government’s recognition that IBRC’s problems cannot be solved via government support and the passage of time was laudable, what is more newsworthy and relevant to the rest of Europe are the arrangements regarding the national debt.
The importance of these revised arrangements goes to the heart of QE theory itself, and stresses the delicate rules upon which QE depends for its continued legitimacy as an instrument of monetary policy. From the documents available and press reports, it seems clear that the original (2009) ECB permission for Ireland’s central bank (the CBI) to monetise its government’s €25 bn ‘promissory notes’ (debt) created specifically to bailout IBRC was conditional on the CBI’s agreement to insist on full repayment by the Irish Government, so that the euros then created could be ‘returned’ to the ECB and extinguished.
Because it was created under the ECB’s Emergency Liquidity Arrangement (ELA) rules prevailing in 2009, however, Ireland also signed up to penal terms - payments of about €3bn, by way of interest and principal, in each of the first ten years. These expensive notes were cancelled on Feb 7 and replaced by 7 tranches of floating rate government bonds with maturities ranging from 25 to 40 years, but at interest rates expected to be at least 5% below the yield on the old notes. This is very attractive to the Irish taxpayer; it is far better to owe redeemable €25 bn of debt over 35 years at a cost of say 4%, than a fast amortising 15-year note with a coupon of 9% and no early repayment option.
Yet, some members of the ECB Governing Council were so strongly opposed to this relaxation of terms that they perhaps tried to frustrate the transaction by leaking its terms to the press after a late night ECB meeting on Feb 5th, resulting in a hastily convened meeting of the Irish Parliament to rush the legislation through and make the public announcements a few days earlier than planned. Why were these ECB directors unhappy?
Well, from the ECB’s perspective there was no need for the Irish government to renegotiate the promissory notes just because they decided to liquidate IBRC. The new arrangements relax the pressure on the Irish to further cut national expenditure, and send a message to others that the strictures of the ELA can be renegotiated almost immediately (Ireland was allowed to miss previous payments). Just as the Irish have benefited, so the rest of the money users of the EU are losers; the QE will not be extinguished for nearly 40 years, and therefore whatever the original expectations were as to the price inflation effect of this Irish QE exercise, they must now be revised upwards.
Banking – Further Collapses, Poor Results and Regulatory Arbitrage.
Most of the big banks reporting figures in February announced bad news. France’s Société Générale posted a 2012 Q4 loss of €476mm, Germany’s Commerzbank lost €720mm.
Motivated doubtless by personal compensation, Britain’s bankers lead the way in spinning losses as ‘good news’. At the end of the month RBS reported losses of over £5bn, Lloyds of about £0.5 bn. Each of these failed banks is embroiled in both the LIBOR rigging and fraudulent (hidden) coupling of insurance products with personal loans. Bonuses have if anything increased for senior managers whose claims of ‘turning around’ their organisations would not withstand the most gentle scrutiny.
Large banks, under Basel II rules, assess the riskiness of their exposures themselves, shadowing the AAA/ AA rating agency calculations without the need to involve a ratings agency. Their assessment approach has to be validated by national regulators, but banks have recently successfully lobbied for lower capital requirements. The net result of this is the increasing leverage of the banking system.
In the logically inverted world of banking, having found a new way of escaping the rigour of Basel III, bankers now seek to publicise their rule gaming achievements rather than hide them; presumably such success drives share prices higher. Deutsche Bank boasted of shrinking risk-weighted assets (RWA) by €26 bn in 2012 Q4; UBS of Switzerland claimed a benefit of SF 8 bn; Sweden’s SEB and Portugal’s BCP also trumpeted their RWA reclassifications.
Should we be horrified? Well, if this banking conduct makes the reader wonder about the quality of monitoring by central bankers, it pales by comparison with news for Italy’s Monte Dei Paschi. Early reports suggest that executives, motivated by personal share stakes, funnelled a secret €2bn 2011 bailout by the Bank of Italy into structured investments boosting MPS share price.