The euro experienced its biggest one-day drop against the yen in seven years this morning as the deepening credit crisis prompted European governments to pledge bailouts for troubled banks while stopping short of giving any concrete programme of coordinated action. The 15-nation currency declined to a 14-month low against the dollar - hitting $1.3598 at 8:52 a.m. in London - and to its weakest in two years versus the yen after European leaders meeting this weekend avoided announcing any plan that would be equivalent to the U.S.’s $700 billion bailout. And the reason for the euro’s fall is clear, the ability of the eurozone countries to apply a concerted startegy to address the problems in the banking and financial system has been called into question, and nowhere is the huge gap between the currency’s ambition and its political architecture so evident as it is in the above two quotes from Jean Claude Trichet. When push comes to shove, the US Treasury, as we have seen last week, does not concentrate on the needs of Florida or Massachusetts, but on those of the entire United States, and who, may we ask is in a position to concentrate at this point on the financing needs of the whole 15 member eurozone-area, since trying to manage economies which are one organic whole by splitting them analytically into monetary and fiscal entitites simply isn’t going to work, and it never was. Let me expain.
The current pressure on the euro is more the result of liquidity and solvency problems in the banking sector (and perceived institutional deficiencies when it comes to being able to address these) than it is a response to the growing weaknesses in the real economies eurozone real economies, which, as I have already recently argued here, probably mean that the zone as a whole has now entered the first recession in its short history.
When it comes to the liquidity and solvency issues, I do think we can already identify some clear trends, since we can see that in those European countries which had substantial housing booms - the UK, Ireland, Greece, Spain and Denmark - the bank exposure is to the drop in the value of the underlying assets (the houses, or the land, or the malls, or the office blocks) and to the defaults in payments (either by builders or by companies, or by homeowners) which have their origin in the impact of the mortgage seize-up on the real economy (rising unemployment, declining bonus payments, falling retail sales and industrial output, etc), whereas in non-housing boom countries (lead by Germany, Italy, Sweden and Austria) the exposure is to lending which was made to banks in the boom countries - first and foremost in the United States, but also in the UK and Ireland (see Germany’s Hypo and it’s Irish subsidiary Depfa) and, of course (and the largest slice of this is yet to come) in Eastern Europe (lead by banks in Sweden, Austria and Italy).
The other key thread is whether or not the institution in question lent against deposits, or depended on the wholesale money markets for funding. The banks - lead in this case by the Spanish armada - who were most dependent on external borrowing are now evidently those who have (or are about to have) the biggest problems as the worlds wholesale money markets remain firmly closed, with little possibility of them being permanently reopened until this crisis is over.
In theory, the 27-nation EU structure should offer a ready means of coordinating policy. But while the EU has unified laws on areas like trade and labour standards (and in the near future on immigration) more broad-reaching policy harmonisation (such as fiscal coordination) has long been resisted, and the recent sorry attempts to introduce a basic constitution provide clear evidence of the difficulties which lie ahead for any substantial moves in this direction. The EU has no institutional equivalent of the US Treasury, which is why all the initiatives which we have seen to date - for all the European “feel” about them - have been either ad hoc bi- or tri- lateral arrangements.
US National Bureau of Economic Research head Marty Feldstein has long been on record as pointing out that the greatest weakness in the eurosystem architecture from the start has been the absence of a common fiscal system, and the inability to correct the problems caused by deficits in one country by drawing on surpluses in another. When he first raised these issues Feldstein was undoubtedly thinking about the possibility of asymetric recessionary processes, and the need to coordinate fiscal stimulus - and I doubt was thinking about a problem of the severity of the one we now face - but in the longer run he has been proved right, this sort of problem was always going to arise at some point or another. As Jean Claude Trichet is now finding out, in macroeconomic management terms you simply cannot have your cake and eat it.
My basic point is a simple one: the European institutional structure with a centralized monetary policy but decentralized fiscal policies creates a very strong bias toward large chronic fiscal deficits and rising ratios of debt to GDP. An effective political agreement among the Eurozone countries is needed to prevent those deficits.
Without either discretionary monetary policy or an automatic cyclical adjustment of interest rates or of the exchange rate, a country can stimulate aggregate demand only by fiscal policy. While a fiscal policy can in principle take the form of a revenue neutral change in fiscal incentives – e.g., an investment tax credit offset by a temporary rise in the corporate income tax rate – the usual fiscal response to an economic downturn is a tax cut that increases the budget deficit. Moreover, deficitexpanding fiscal policy has greater potency with the interest rate and exchange rate essentially fixed than it would if the country had its own currency.
There is also a greater need in Europe than in the United States to use discretionary fiscal policy to respond to an economic downturn in a “local” area – i.e., in a European country or an American state. This reflects both fundamental labor market differences between Europe and the US and differences between the two fiscal systems. By fundamental labor market differences I mean the much greater geographic mobility and wage flexibility in the US than in Europe. A sharp decline in demand for the products of Massachusetts, my own state, some years ago led to a relative decline in the Massachusetts labor force (more out-migration and less in-migration) and to a decline in the relative wage of Massachusetts workers. The European labor force is much less mobile (because of differences in language and culture and a general reluctance to move even within countries) and wages are much less flexible.
The contrast between the centralized fiscal system in the United States and the decentralized fiscal system in Europe is also very important in this context. A decline of economic activity in a single US state automatically causes a substantial decline in the flow of taxes to Washington from residents and businesses in that state and an increase in transfer payments from Washington. The magnitude is roughly equal to 40 percent of the local decline in GDP. This net fiscal swing constitutes a significant external fiscal stimulus to the local economy. In contrast, with the decentralized European fiscal system, a fall of GDP in any country causes a contraction in tax revenue in that country but very little net transfer from outside. In short, the combination of a centralized monetary policy and a decentralized fiscal structure in Europe increases the need for and the effectiveness of countercyclical fiscal policy.
Marty Feldstein, The Euro And The Stability Pact
The issue really is that any economy is a single organic whole, and that monetary and fiscal policy really form part of one integral continuum. Basically both are concerned with demand management, monetary policy via the indirect route of trying to influence peoples saving and borrowing behaviour, and fiscal policy via the direct route of either injecting or withdrawing demand from an economy. Trying to manage one without having control over the other simply ends up in incoherence at the end of the day, and it is just this policy incoherence that we are in danger of seeing now as the financial crisis (and the political credibility one which is liable to follow in its wake if people aren’t careful) takes hold. Basically economies like Spain and Ireland, where the real economies are now almost in free fall (Spain’s industrial output fell at the fastest rate of any among the 26 key global economies tracked on the JPMorgan global purchasing managers index in September) need a substantial injection of funds via the fiscal conduit to enable their governments to inject liquidity and demand into their systems without those governments seeing their accumulated debt to GDP ratio’s rising at rates which will set of alarm signals over at the credit ratings agencies. And they need this funding now, since - and without wanting to sound too dramatic - the situation is deteriorating rapidly, and by the day.
Unicredit Sinks Like A Stone
The shares of Italy’s second largest bank, UniCredit SpA, fell as much as 16 percent at one point in Milan trading this morning, hitting 2.59 euros and taking the shares back into the region of the 11-year low of 2.55 euros registered on Sept. 30. The drop follows a capital boost of 6.6 billion euros decided on at an emergency board meeting held yesterday afternoon, where among the exceptional measures decided on to raise the cash was the idea of paying this years dividends to shareholders by giving them more company shares.
The “shares for dividends decision” forms part of a battery of measures which includes significant cost cuts and asset sales in order to try to guarantee that the core Tier I capital ratio, a measure of the banks’ financial strength, rises to 6.7 percent by the end of the year, from 5.7 percent now. A core Tier I of 6 percent or higher is generally considered an adequate minimum for banks, while anything below it starts to raise eyebrows.
During a chaotic day trading in Unicredit shares was suspended several times following the initial dramatic fall, and they were finally down on the day by 5.5 percent, closing at 2.914 euros. Indeed the problems being experienced at Unicredit lead the whole Italian banking sector down, and with it Italy’s S&P/MIB Index, which declined the most in more than seven years this morning, losing 1,435, or 5.5 percent, to 24,476.
But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.
Wolfgang Munchau, The Financial Times, Monday 6 October 2008
UniCredit SpA, is, as I say, Italy’s second biggest bank and it is also owner of Germany’s HVB Group. The current crisis started last week when shares fell more than 24 percent in three days as it became increasingly clear that the bank was going to need to raise money to strengthen its finances. One of the issues arising was whether or not UniCredit would be asked to help in the bailout of Germany’s Hypo Real Estate Holding, a development which could have negative consequences for Unicredit’s capital position. Hypo Real Estate was in fact spun off from the Unicredit owned HVB Group in 2003.
But Unicredit is also exposed due to the extent of its lending in Eastern Europe - which is estimated to amount to one quarter of the banks total lending operations. Unicredit is deeply involved right across Eastern Europe via its ownership ofthe HVB group, as well as via it’s ownership of Bank Austria Creditanstalt. Among other issues Unicredit is evidently exposed in the Baltics, given the fact that as of September 1, 2007 ASUniCredit Bank Estonian took over the business of HVB Bank Tallinn. But the extent of Unicredit East European lending is much more extensive than this, and with property markets in one EU10 country after another now likely to “correct” the problem is about to become considerably larger than simply the German Hypo Real Estate one. Unicredit made direct acquisitions in 2007 in Kazakhstan and Ukraine, while extending its position in the Russian banking sector. The first of these counries had a financial “sudden stop” in September 2007, while the latter two are in the process of a major domestic credit “unravelling.
Fitch Ratings last Thursday downgraded the Outlook on UniCredit to Negative from Positive. At the same time Fitch changed the Outlook on Unicredit’s main subsidiaries - Germany-based Bayerische Hypo- und Vereinsbank AG (HVB) and Austria-based Bank Austria Creditanstalt AG - to Negative from Positive. Fitch stressed as reasons for the downgrade the poor macroeconomic outlook in Italy and Germany and in particular the less benign outlook for some central and eastern European markets. Fitch also regards UC’s current capitalisation (end-H108 Basel 1 core Tier 1 ratio of 5.55%) as tight in relation to its risks especially given thatconditions in the wholesale funding market remain “extremely challenging”.
So the question is going to be, is Unicredit too big to fail, or too big to save?
Government Guarantees For Deposits
One popular way of handling the present wave of pressure hitting the banks has been to give guarantees to depositors. The Irish were the first to do this, and they have been subsequently followed by The Greeks, the Danes, the Swedes and now the Germans. Up to this point the Italian and Spanish authorities have been notably silent on the matter, and the reason why is not hard to imagine.
Basically Ireland may have quite large problems, but it can, being a small country, “piggy back” from the United Kingdom, by attracting deposits from their larger neighbour. An analysis carried out at Credit Suisse has shown how movements of cash by relatively few depositors may have a bigger effect in countries which a significant proportion of deposits is concentrated among relatively small percentage of the customer base, as is the case in the U.K. (for example) where 4 percent of the banks’ customers hold 45 percent of the deposit base.
But where can the Spanish banks look for this kind of support? It is their very size and the size of the problem they have that makes for the difficulty. The vaguely-insinuated plan which was “nearly - but never actually - proposed” at last Saturday’s Paris meeting was for a fund of 300 billion euros. But Germany’s Die Welt reported over the weekend that Hypo Real Estate alone will need 20 billion euros by the end of next week and 50 billion euros by the end of the year, to be followed by as much as 100 billion euros by the end of 2009. And this is just one relatively minor “quasi bank”.
Spain’s needs are likely to be much larger - I personally have estimated a sum of between 300 and 500 billion euros for Spain alone, between the need to roll-over toxic financial instruments and non-performing loans from builders and other corporates. And what about Unicredit? We have no real idea at this point how much funding Unicredit may need.
And so we need to go back to Marty Feldstein, and to think about the budget deficits issue. In general European governments have little room for large scale fiscal support either on the annual deficit side, or on the debt to GDP ratio one. Given the ageing-related commitments (pensions, health costs) which are looming (in particular after 2012) for some key European governments (especially Germany and Italy) it is reasonably clear that - following the deficits which were all too often being run during the “good years” - there is now not much headroom to play around with, and remember all this government support for banks that is bbeing freely undertaken has to be funded somehow - either out of revenue, or by raising debt. In particular, if certain of the EU national governments move back on the commitment to balance the budgets by 2011 then we will only start to shift from banking instition downgrades to sovereign rating ones. This is why I titled this post the way I did. If either Italian government finances, or the Spanish banking system, are simply allowed to unwind for lack of visible support, then the integrity of the Eurozone itself which most definitely be put at risk. And events could happen very rapidly indeed if either important systemic banks or a large sovereign government suddenly go into financial meltdown. So the visible lack of any coherent startegy or plan could not be reasonably considered one of those cases where some people somewhere busy fiddling with their thumbs while Rome and Madrid were burning, now could it?
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Feed: A Fistful of Euros