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Satyajit Das on the Eurozone Debt Crisis: It's Now About Germany


In the end, German citizens will have to pay twice for the euro, if not more.


German Fetishes

Germany's strengths, especially its export fetish, are weaknesses.

Exports are over 40% of Germany's GDP, compared to less than 20% in Japan and about 13% in the US. Germany's current account surplus, which is larger than China's when measured as a percentage of its GDP, is a source of pride. Exports have provided the majority of Germany's growth in recent years.

Germany is heavily reliant on a narrowly based industrial sector, focused on investment goods -- automobiles, industrial machinery, chemicals, electronics, and medical devices. These sectors make up a quarter of its GDP and the bulk of exports.

The improvement in German competitiveness may also be overstated. Germany entered the eurozone with an overvalued exchange rate. This exaggerated the extent of Germany's adjustment.

Germany's service sector is weak with lower productivity than comparable countries. While it argues that Greece should deregulate professions, many professions in Germany remain highly regulated. Trades and professions are regulated by complex technical rules and standards rooted in the medieval guild systems. Foreign entrants frequently find these rules difficult and expensive to navigate.

Despite the international standing of Deutsche Bank (DB), Germany's banking system is fragile. Several German banks required government support during the financial crisis.

Highly fragmented (in part due to heavy government involvement) and with low profitability, German banks, especially the German Länder (state) owned landesbanks, face problems. They have large exposures to European sovereign debt, real estate, and structured securities.

Prior to 2005, the landesbanken were able to borrow cheaply, relying on the guarantee of the state governments. The EU ruled these guarantees amounted to subsidies. Before the abolition of the guarantees, the landesbanks issued large amounts of state-guaranteed loans which mature by December 2015. With limited access to retail deposits (primarily held with mortgage banks known as Sparkassen) and no state guarantee, the landesbanks' ability to refinance maturing debt in international markets remains uncertain.

While it insists on other countries reducing public debt, German debt levels are high -- around 81% of GDP. The Bundesbank, Germany's central bank, has stated that public debt levels will remain above 60% (the level stipulated by European treaties) for many years.

German public finances are also vulnerable to the demographic problems of a rapidly aging and shrinking population. As increasing numbers of workers retire, tax revenues will decline and pension and health care costs rise.

Caught in a Trap

Germany's greatest vulnerability is its financial exposures from the current crisis. German exposure to Europe, especially the troubled peripheral economies, is large.

German banks had exposures of around US$500 billion to the debt issues of peripheral nations. While the levels have been reduced, it remains substantial, especially when direct exposures to banks in these countries and indirect exposures via the global financial system are considered.

The reduction in risk held by private banks has been offset by the increase in exposure of the German state which assumed some of this exposure. This was done either directly or indirectly through indirect support of various official institutions such as the European Union ("EU"), European Central Bank ("ECB"), the International Monetary Fund ("IMF") and specially bailout funds.

For example, the exposure of the ECB to Greece, Portugal, Ireland, Spain, and Italy is Euro 918 billion as of April 2012. This exposure is also rising rapidly, especially driven by capital flight out of these countries. The Financial Times reported on May 21, 2012 that the ECB had provided the Greek Central Bank with an undisclosed Euro 100 billion to assist Greek banks under it Emergency Loan Assistance ("ELA") facility.

Germany's guarantees supporting the European Financial Stability Fund ("EFSF") are Euro 211 billion. As Spain could not presumably act as a guarantor of the EFSF once it asks for financing, Germany's liability will increase further from 29% to 33%. France's share also increases from 22% to 25%. Perhaps most interestingly, the liability of Italy, which is in poor shape to assume any additional external financial burden, rises from 19% to 22%.

The European Stability Mechanism, the replacement to the EFSF which is planned to commence in July 2012, will require a capital contribution from Germany which will push its budget deficit from Euro 26 billion to Euro 35 billion. If the ESM lends its full commitment of Euro 500 billion and the recipients default, Germany's liability could be as high as Euro 280 billion.

Since 2010, the eurozone has committed Euro 386 billion to the bailout packages for Greece, Ireland, and Portugal. In June 2012, Spain is expected to request at least Euro 100 billion for the recapitalization of the banking system, making the total commitment just below Euro 500 billion.

But the largest single direct German exposure is the Bundesbank's over Euro 700 billion current exposure under the TARGET2 ("Trans-European Automated Real-time Gross Settlement Express Transfer System") to other central banks in the eurozone.

Designed as a payment system to settle cross border funds flows, surplus countries, like Germany, have been forced to use TARGET2 to finance deficit countries. Before 2008, deficits were financed by banks and investors. Since the crisis commenced, TARGET2 has been used to meet the funding needs of peripheral countries without access to money markets to fund trade deficits and the capital flight out of their countries.

Germany is by far the largest creditor in TARGET2. The Netherlands, Finland, and Luxembourg are the other creditors with all other eurozone countries being net debtors within the system.

Germany is now caught in a trap. Irrespective of the resolution of the debt crisis, Germany will suffer significant losses on its exposure – it will be the biggest loser. As Elvis Presley once sang in "Suspicious Minds": "We're caught in a trap I can't walk out because I love you too much baby."

No positions in stocks mentioned.

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