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Satyajit Das on the European Debt Crisis


The half-life of solutions to Europe's debt problem is getting ever shorter.


Recent hopes have relied on the ostensible success of the European Central Bank's (ECB) LTRO -- Long Term Refinancing Operation, more appropriately termed the Lourdes Treatment and Resuscitation Option. In December 2011 and February 2012, the ECB offered unlimited financing to European banks at 1% for three years, replacing a previous 13-month program. Banks withdrew over euro 1 trillion under the facility -- euro 489 billion in the first round and euro 529.5 billion in the second. Participation among European banks was widespread, especially in the second round with about 800 banks using the facility.

The borrowed funds were used to purchase government bonds, retire or repay existing more expensive borrowings, and surplus funds were re-deposited with the ECB. The first entailed banks borrowed at 1%, purchasing higher-yielding sovereign debt such as Spanish and Italian bonds that paid 5-6%. This allowed banks to earn profits from an officially sanctioned carry trade -- known as the Sarko trade after the French president.

The LTRO provided finance for both beleaguered sovereigns and banks, which will need to raise around euro 1.9 trillion in 2012. It helped reduce interest rates for countries like Spain and Italy. It also helped banks covertly build up capital via the profits earned through the spread between the cost of ECB borrowings and the return available on sovereign bonds.

The LTRO was very clever, effectively monetizing debt (printing money) without breaching European treaties or the ECB's charter.

The amount of money was massive -- at one euro 500 note per second, it would take 63.5 years count to euro 1 trillion -- but financial market sentiment was overwhelmingly positive, feeding a large rally in global stock markets and other risky assets.

As subsequent events have exposed, there were always reasons to be cautious.

The LTRO facility is for three years. It assumes that the conditions will normalize within that period. It is not clear what happens if that is not the case.

Economist Walter Bagehot advised that, in a crisis, central banks should lend freely, but at a penalty rate and secured by good collateral. The ECB does not appear to have quite understood Bagehot's commandment. The rate is below market rates, amounting to a subsidy to banks. The ECB and eurozone central banks have loosened standards, agreeing to lend against all manner of collateral. In effect, the ECB is now functioning as a financial institution, assuming significant credit and interest rate risks on its loans.

If the European Financial Stability Fund (EFSF) was a collateralized debt obligation, the ECB increasingly resembles a highly leveraged bank.

The ECB balance sheet is now around euro 3 trillion, an increase of about 30% just since Mario Draghi took office in November 2012. It is supported by its own capital (scheduled to increase to euro 10 billion) and the capital of eurozone central banks (euro 80 billion). This equates to a leverage of around 38 times.

Critically, the LTRO cannot address fundamental issues.

It does not reduce the level of debt in problem countries; it merely finances them in the short-run. Europe is relying on its austerity program to reduce debt. As Greece demonstrated and as Ireland, Portugal, Spain, and Italy are currently demonstrating, massive fiscal tightening when combined with private sector reduction in debt merely puts the economy into recession. As public finance deteriorates rather than improves, there will be an increase, not decrease, in public debt.

Ultimately, it may be necessary to go Greek. For many countries, debt restructuring may be needed to achieve the required reduction in the public borrowings. Interestingly, financial markets price the risk of a Spanish debt restructuring at around 30-35%.

The LTRO does not improve the cost or availability of funding for the relevant countries beyond an immediate short term fix.

Government bond purchases financed by the LTRO artificially decreased the interest rates for countries, such as Spain and Italy. Unless additional rounds of LTRO are offered, interest rates are likely to return to market levels.

The real increase in liquidity available to support sovereign borrowings was lower than euro 1 trillion. Perhaps only one-third of the LTRO loans and maybe as little as euro 115 billion were directed to this purpose. Banks used the bulk of funds to repay their own borrowings. As debt becomes due for repayment through the year, banks may need to sell sovereign bonds purchased with the funds drawn under the LTRO. Unless market conditions normalize and banks regain access to normal funding quickly, this will place increasing pressure on sovereign funding and its cost.

With European countries facing heavy refinancing programs in 2012 and beyond, the ability to raise funds at reasonable rates remains important. Existing bailout programs assume countries like Portugal and Ireland will be able to resume financing in money markets normally from 2013.

Events complicate the ongoing commercial financing of European banks and sovereigns. The need for collateral to support ECB funding makes other investors de facto subordinated lenders, reducing their willingness to lend or increasing the cost. In the Greek restructuring, European Central Banks and official institutions were exempted by retrospective legislation from loss while other investors suffered 75% writedowns. This has reduced investor willingness to finance countries that are considered troubled.

European banks already have large exposures to sovereign debt, which has increased since the start of the LTRO. Spanish banks are thought to have purchased around euro 90 billion, a jump of around 26% to euro 220 billion. Italian banks are thought to have purchased euro 50 billion, a jump of 31% to euro 270 billion.

Similar rises in government bond holding have occurred in Portugal and Ireland. As interest rates on these bonds have increased, buyers now have large unrealized mark-to-market losses on these holdings.

As with the sovereigns, the LTRO does not solve the longer term problems of the solvency or funding of the banks, which now remain heavily dependent on the largesse of the central banks. It is a government-sponsored Ponzi scheme where weak banks are supporting weak sovereigns which, in turn, are standing behind the banks -- a process that can be best described as two drowning people clinging to each other for mutual support.

The LTRO has not materially increased the supply of credit to individual and businesses. The money is being used by banks to finance themselves as they reduce borrowings by selling off assets to reduce dependence on volatile funding markets. The LTRO does little to promote desperately needed economic growth in the eurozone.

The initial euphoria faded as a number of concerns reemerged, manifesting themselves in the form of increasing rates on Spanish and Italian debt, which now hover around the key level of 6.00% per annum.

Increasingly poor economic growth figures from Europe pointed to a lack of growth and progress on debt reduction.

Attempts to reduce Spain's deficit has proved problematic. Both Spain and Italy have deferred balancing their budget in the face of a deteriorating economic outlook. It is unclear which outcome markets fear most -- Spain and Italy not achieving their targets through savage spending cuts that result in higher debt, or the countries achieving their targets and putting their economies into an even deeper recession and increased debt.

The difficulties faced by Spanish Prime Minister Mariano Rajoy and Italian Prime Minister Mario Monti in implementing labor reforms have highlighted the resistance to structural change. Increasing protests in many countries point to the political difficulty in implementing the agreed austerity measures.

The problems of the banking system have resurfaced. Spanish banks' bad and doubtful debts have increased, as the Iberian property bubble deflates. Increased reliance by Spanish and Italian banks on financing from central banks has heightened concern. Spanish bank borrowings from the ECB increased to over euro 300 billion in March from euro 170 billion in February. Lending to Spanish banks now accounts for nearly 30% of total ECB lending. Italian banks have also been heavy borrowers, a reminder of the linkage between banks and their sovereigns.

Reluctance to increase the inadequate European firewall sufficiently to deal with potential problems means policy options are limited. At around euro 500 billion in available funds, the bailout fund is short of the euro 1 trillion sought by the International Monetary Fund and G-20, and the euro 2-3 trillion thought necessary by financial markets. German leaders have repeated their unwillingness to increase the fund to the necessary size, arguing, probably correctly, that no firewall will be adequate.

Poorly judged and ill-timed comments by ECB President Draghi about the absence of need for further LTRO funding and planning for an exit drew attention to the fragility of the position and ongoing risks. The comments were driven by Bundesbank unease at the ECB's policy. The market reaction forced Mario Draghi to retract his comments about an early exit from emergency funding. As rates continued to rise, Benoit Coeure, the French ECB board member, promoted a new round of direct purchases of Spanish bonds to reduce yields.

The failure of the LTRO to decisively solve European problems is unsurprising. Confidential analyses prepared by European Union officials and distributed to ministers meeting in Copenhagen in March 2012 concluded that the euro 1 trillion in loans was a "reprieve" rather than a solution.

Rather than take the time afforded to move on other fronts, European leaders reverted to type. Spanish Finance Minister Luis de Guindos opined that: "We are convinced that Spain will no longer be a problem, especially for the Spanish, but also for the European Union." It was eerily reminiscent of his predecessor Elena Salgado, who almost exactly one year earlier on April 11, 2011 said: "I do not see any risk of contagion. We are totally out of this." The optimism was echoed by French President Nicolas Sarkozy, who was confident that the eurozone had "turned the page." Italian Prime Minster Mario Monti stated that the "financial aspect" of the crisis had ended.

The European debt crisis is not over. Fundamental problems -- debt levels, trade imbalances, problems of the banking sectors, required structural reforms, employment and economic growth -- remain.

Beyond the German-favored remedy of asphyxiating austerity to either cure or kill the patient, Europe is rapidly running out of ideas and time to
deal with the issues. As the real economy stalls and debt problems continue, the most likely policy actions may come from the ECB -- an interest rate cut to near zero and further liquidity support, perhaps even full-scale quantitative easing. Bailout funds may be channeled to recapitalie Spanish banks, as a means of helping Spain without resorting to a full-blown bailout package.

It is doubtful whether any of these steps will work.

European politicians and citizens want a quick return to a period Spaniards now refer to as cuando pensábamos que éramos ricos, which translates to English as "when we thought we were rich." Official policies and action are focused on deferring rather than dealing with the problem. Unfortunately, that means the inevitability of meeting the same problem somewhere down the road.

John Maynard Keynes observed in The Economic Consequences of the Peace that each action designed to bring closure to one crisis sows the seeds of greater economic, political, and social problems. Europe is living the truth of that statement one day at a time.

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