An Intractable Problem

Something that keeps exercising our mind is the seeming contradiction between two stances uttered as firm principles by the German political leadership. The first is that often repeated assertion that it is determined to ensure the euro's survival. The second is the equally often repeated assertion that using the ECB's printing press to stem the run on euro area sovereign bonds is completely out of the question.


The reason why these two stances may prove to be irreconcilable is that the markets are trying to force the issue. Recent news indicate that not even Germany – the bond market of which is the 'last man standing' in the euro area – can rely  anymore on buyers showing up at its bond auctions. In fact, as the Telegraph reported a few days ago, Asian investors are busy ditching investments in European sovereign bonds, including German bonds, until some coherent plan emerges.

We are well aware what Germany and the ECB want to achieve. By playing hardball, they have forced out several governments that were seen as unreliable with regards to implementing fiscal austerity. What has happened in Italy and Greece were basically bloodless coups, installing bankers (the so-called 'technocrats') at the helm of these governments.

Germany now pushes for a swift implementation of EU treaty changes in order to make it possible for Brussels to legally take away the fiscal sovereignty of any euro area member state seen to violate the stability pact's rules. Given the non-existent implementation of everything that has been agreed upon thus far, this plan seems overly ambitious, to put it politely. If you're less polite, you could also call it the joke of the month.

The obvious problem is that the markets will no longer give the eurocrats any more time to come up with something credible. Whenever there was a breathing space provided by a lull in market pressure over the past 18 months,  there seemed to be a corresponding lull in the drive toward reform. Valuable time was wasted. Now it is essentially 'game over' – the pressure simply keeps building, day after day.

Since it is an undeniable fact that neither Spain nor Italy can afford their interest rates to be stuck near 7% or higher, a vicious spiral similarly to what was seen with the 'GIP' trio seems all but assured. At the same time, the markets are now attacking Belgium, which has become the latest market focus, as well as France, which is rated AAA by the credit agencies, but not by the markets.

“Investors aren’t waiting for Standard & Poor’s or Moody’s Investors Service to strip France, Europe’s second-biggest economy, of its top credit rating.

The extra yield demanded to lend to AAA rated France for 10 years was 158 basis points more than the German rate at 11:51 a.m. today. The gap was 200 basis points on Nov. 17, the widest spread since 1990, up from 28 in April. The French 10-year yield was at 3.5 percent, about midway between top-rated Holland and Belgium, which is graded one level lower at Aa1 by Moody’s. French borrowing costs are more than a percentage point above the AAA rated U.K.

“France isn’t trading like a AAA,” said Bill Blain, a strategist at Newedge Group in London, who recommends buying U.K. government debt. “The market has made its judgment already.”

(emphasis added)

This means that an official downgrade of France's credit rating is only a question of time – and time is growing short. Once that happens, the entire – not yet implemented, mind – leveraged EFSF bailout plan is dead, once and for all. Similarly, Belgium's credit rating is likely to be downgraded within days, in the wake the inability of its political parties to either form a government or – more importantly – decide on a budget.

Meanwhile, Greece's bailout once again hangs in the balance, as Antonis Samaras continues to refuse to sign any pledges to the EU – which has prompted Jan Kees de Jager, the Netherlands' minister of finance, to drily state: “We want a signature from this Mr. Samaras. Otherwise they won't get money, absolutely not."

Meanwhile, the euro area's banking system finds itself under ever more funding stress. The disarray is best illustrated by the fact that borrowings from the ECB have rocketed to a new high for the year.

Weekly borrowings by banks from the European Central Bank soared to their highest level this year while the cost of borrowing euros in the interbank market stayed at its highest in two weeks Tuesday despite plentiful cash in the system, highlighting strains in money markets as the debt crisis deepens.

The ECB Tuesday allotted EUR247.175 billion in its seven-day funds at its weekly main refinancing operation at a fixed rate of 1.25%, up considerably from the previous 2011 high of EUR230.265 billion hit at last week’s tender. The number of bidders at the weekly operation rose to 178 from 161 a week earlier.

The three-month Euro Interbank Offered Rate, or Euribor, was unchanged at 1.467%, having nudged higher for four days running. But that rate is still below the levels hit earlier this year.

Distrust among banks is growing as fears mount that upheavals in the bond market will contaminate banks’ balance sheets. That is prompting some banks to hoard cash while forcing banks that are shut out of money markets to turn instead to the ECB for funds.

While the amount of excess liquidity in the banking system has increased, risk-averse banks are parking these funds with the ECB instead of lending them.

Italian and Spanish bond yields remain at levels that, if sustained over a long period, will severely strain public finances. The crisis is also spreading to larger triple-A-rated countries, with the extra yield demanded by investors to hold French bonds instead of safe-haven German bunds widening to a euro-era record last week.

“With the pressure in the banking sector related strictly to the sovereign debt crisis, the functioning of the euro repo market has been affected severely by the recent increase in risk aversion,” interest rate strategists at Barclays Capital said in a note to clients.

“The average maturity of the operations has been reduced sharply and, at present, term liquidity (say from 3-month onwards) is not available in the market,” they said.”

(emphasis added)

In short, the markets are no longer prepared to wait for Germany's latest proposals to come to fruition. In fact, they arenot even prepared to wait for the implementation of the already taken EFSF-related decisions. Things are coming to a head, right here and now.

The Likely Shape of 'Plan B'

We might as well call it 'Plan 9 from Outer Space', but we already used that one on another occasion (when lampooning Paul Krugman's nutty idea to fake a space alien invasion to force more 'deficit spending').

What we are referring to here is a thought that simply refuses to go away, namely: how are they going to do it?

In light of the contradictions inherent in Germany's stance highlighted above, the question remains how much longer it can remain steadfast regarding  its refusal to deploy the ECB's printing press.  Simply put, while it is true that money printing can not 'solve' anything, it is equally true that if the rise in Spanish and Italian yields continues, the euro area will likely break apart in 'disorderly' fashion within weeks.

We assume that there therefore has to be a 'Plan B' in a drawer somewhere. This week we have come across two news items that seem to offer a possible way for Germany and the ECB to relent in a manner that might  help them to save face as well as ensuring that the 'bailout recipients' have no choice but to adhere to the austerity demands of Brussels (or rather, Berlin and Frankfurt).

First it was reported a few days ago that the ECB could skirt the legal obstacles that keep it from lending to governments via a detour: its statutes do allow it to lend to 'foreign institutions', including the IMF.  As Reuters reported:

Euro zone and International Monetary Fund officials have discussed the idea of the European Central Bank lending to the IMF, to provide the fund with sufficient resources for bailing out even the biggest euro zone sovereigns, officials said.

"Some discussions on this have taken place… It could be one way of getting around the legal restrictions on the ECB," one official with knowledge of the talks said. A second official said ECB lending to the IMF was being explored.

The idea appears as the rising severity of the euro zone debt crisis, which now threatens to engulf Italy, or even France, makes policymakers desperate to get the ECB, with its limitless resources as a central bank, more involved in the rescue efforts to buy governments time for reforms.

Economists say only the ECB now can offer a credible guarantee to markets, as plans to leverage the firepower of the euro zone bailout fund EFSF to 1 trillion euros were unlikely to fully materialise or, even if they do, to be sufficient.

But EU law forbids the ECB to finance government borrowing. The bank has repeatedly said it would not become the lender of last resort to euro zone governments, which should first of all change policies that created large public debt and slow growth.

France has openly called for the ECB to get more involved by issuing the euro zone bailout fund — the European Financial Stability Facility (EFSF) — a banking licence that would allow it to refinance itself with the ECB liquidity operations.

Yet Germany fiercely opposes such an idea, fearing it would lead to financing government deficits, endanger the ECB's independence and in the end lead to higher inflation, which would make all euro zone citizens poorer.

Policymakers have discussed, therefore, how to get the ECB involved in crisis-fighting without endangering its independence. Lending money to the IMF, rather than any euro zone government, could achieve that, officials said.

"It is just an idea, at least for now," a euro zone official said.

Article 23 of the ECB statute says that "the ECB may conduct all types of banking transactions in relations with third countries and international organizations, including borrowing and lending operations."

The IMF could then use the ECB money to finance various rescue operations in the euro zone like bailouts, precautionary credit lines, on its own, or in cooperation with the EFSF.”

(emphasis added)

Yesterday the IMF announced that it is now implementing one of the decisions taken during the G-20 meeting in early November, namely the increase in credit lines to IMF member nations in 'distress'. Essentially members can leverage their SDR allocation five times, which adds up to a sum that is probably not significant enough to stem the crisis. However, we rather see it as a first step toward implementation of the idea mentioned above – namely the activation of  the ECB's printing press without the ECB having to violate its statutory limits regarding lending to governments. 'IMF beefs up lending tools' as Reuters reported yesterday:

“The IMF on Tuesday beefed up its lending instruments and launched a six-month liquidity line, throwing help to countries with solid policies that may be at risk from the euro zone debt crisis.

By updating its lending tools, the IMF hopes to ensure it can make liquidity available to countries that may be struck by contagion from the crisis, as opposed to nations already deep in the mire.

The announcement comes as concern grows over a crisis that has moved from debt-stricken Greece to larger economies such as Italy and Spain where bond yields have risen sharply, raising questions about the euro's very survival.

The IMF said it was establishing a precautionary liquidity line as "insurance against future shocks and as a short-term liquidity window to address the needs of crisis bystanders." The IMF said the new liquidity line would be available for six months to countries with relatively good policies that are facing short-term balance of payments needs due to events not of their own making.

Access under the six-month arrangement could be as much as 500 percent of a IMF member nation's quota, and the funds would come with few conditions. IMF quotas are calculated roughly according to the size of a country's economy, trade and reserves, and they determine the amount each nation can borrow from the global lender. The new instrument, called the Precautionary and Liquidity Line, could also be used for longer programs under 12- to 24-month arrangements, with access up to 1,000 percent of a member's quota, the IMF said. This arrangement would come with more IMF conditions attached and would be subject to regular reviews by the IMF board, it said.

The IMF did not elaborate on which countries could qualify for the arrangements.

The fund also adopted a new rapid financing instrument for nations facing urgent balance-of-payment needs caused by so-called exogenous shocks, such as countries in the Middle East and North Africa hit by political upheaval. It will also be available to countries hit by natural disasters. Funding under the instrument would be available immediately, with access of up to 100 percent of members' quotas.

"We have acted quickly, and the new tools will enable us to respond more rapidly and effectively for the benefit of the whole membership," IMF Managing Director Christine Lagarde said in a statement.”

(emphasis added)

Contrary to the euro-group, the IMF appears to be somewhat faster in implementing decisions. To us it seems now highly likely that an ECB-IMF tag team approach to the crisis is in the works. As highlighted above, the IMF would be in charge, as the lending would come 'with conditions attached and subject to regular reviews'.

This is what would allow the ECB and Germany to save face, as it would ensure that the governments concerned would have to stay on course with regards to to implementing austerity. At the same time, financing the IMF efforts via the ECB would deflect criticism that the euro area is getting money from other IMF member nations for a problem that is within its own capacity to solve.

If market pressures continue to build in coming days and weeks, we believe the probability is high that an arrangement of this sort is going to be announced. The printing press won't stay idle after all.

Below are the charts illustrating the recent attack on the bonds of the latest victim of the crisis, Belgium. CDS on Belgium and France both have reached new all time highs on Tuesday.


10 year government bond yield of Belgium – this one is about to join the 'PIIGS' in terms of bond market distress – click for higher resolution.


10 year government bond yield of Belgium, long term – breakout! – click for higher resolution.


5 year CDS on Ireland, Japan, France and Belgium: CDS on Belgium reach a new all time high of about 354 basis points. CDS on France are at a new all time high as well – click for higher resolution.

Charts by: Bloomberg



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2 Responses to “The ‘Print or Die’ Conundrum”

  • jchan:

    I’ve been thinking about your comment that the changes of government in Greece and Italy were basically “bloodless coups.” Down the road, these impositions may come back to haunt Europe, because the people always have the option, from this point forward, of viewing the government as illegitimate. Whenever citizens can say to themselves, without any feelings of doubt, that their government is not legitimate and has been imposed on them by outside powers, they can also justify all kinds of resistance and violence as patriotic action. All the more reason to think of Greece, Italy, and the others as political powder kegs, and not just as time bombs of financial ruin.

    • I absolutely agree with this train of thought. A lot of things have been imposed from above by the eurocrats, but one day they will be overstepping the bounds. Especially during times of economic contraction the mood of the people eventually always tends to turn against the incumbent rulers, all the more so when their legitimacy is in doubt.

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