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

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

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No Exit

Advocates of European unity believe greater monetary and fiscal integration is the solution. They argue that the eurozone's current account is nearly balanced, its trade account has a small surplus, the overall fiscal deficit is modest, and the aggregate level of public debt is manageable.

Integration would require mutualization of debt through the issue of eurozone bonds backed jointly or severally by all member states. In late May 2012, French President Francois Holland provided a curious argument in support of eurozone bonds: "Is it acceptable that some sovereigns can borrow at 6% and others at zero in the same monetary union?" While music to the ears of Spanish and Italian leaders, Germany was understandably reluctant to embrace the mutualization of European sovereign debt. As the largest, most creditworthy nation in the eurozone, Germany would bear the largest financial burden. Its exposure would increase through its liability for eurozone bonds.

Fund manager John Hussman summarized the idea of eurozone bonds neatly: "This is like nine broke guys walking up to Warren Buffett and proposing that they all get together so each of them can issue "Warrenbonds." About 90% of the group would agree on the wisdom of that idea, and Warren would be criticized as a "holdout" to the success of the plan."

Germany's TARGET2 exposure would also continue to increase, at a rate of Euro 80-160 billion per annum to finance expected trade deficits in the rest of Europe. The increase in exposure may be higher if needed to finance budget deficits of weaker eurozone members and the weak banking sector. Germany's TARGET2 exposure has increased by around Euro 237 billion or around 34% in the last eight months alone.

Political will for integration is lacking. Germany is reluctant to become the ultimate guarantor of the eurozone. Bundesbank President Jens Weidmann put the German position on eurozone bonds bluntly: "You cannot give someone your credit card without having the means to control the spending." He also appeared to indicate concern about further activism from the ECB: "The European Central Bank has reached the limit of its mandate, especially in the use of its non-conventional measures." Most importantly, Mr. Weidman pointedly told Le Monde: "In the end, these [measures] are risks for taxpayers, most notably in France and Germany."

As a result, Europe may be forced to rely on its current policy of partial solutions -- austerity and monetary accommodation by the ECB. As the troubled economies are unlikely to regain access to commercial funding in the near future, the debt of peripheral nations will shift to official institutions via bailouts, funding arrangements and the TARGET2 system. Germany's financial liability will increase in this case.

In the peripheral economies, continued withdrawal of deposits from national banks (a rational choice given currency and confiscation risk) may necessitate either a Europe-wide deposit guarantee system or further funding of banks.

The amounts involved are substantial. Bank deposits in the eurozone total around Euro 7.6 trillion, including Euro 5.9 trillion from households. The eurozone's peripheral countries, which are most susceptible to capital flight, have Euro 1.8 trillion in household deposits. In the first 3 months of 2012, Euro 97 billion of deposits were withdrawn from Spanish banks.

A credible deposit insurance scheme would have to cover household deposits (say up to Euro 100,000), which is around 72% of all deposits, in the peripheral countries. This would entail an insurance scheme for around Euro 1.3 trillion of deposits.

As noted above, in early June 2012, the Spanish government sought Euro 100 billion from the eurozone to recapitalize its banks. A single Spanish bank – Bankia (BNKXF) – will require more than Euro 19 billion of new capital. To date, including the Bankia commitment, the Spanish government already has injected to Euro 33 billion (3% of gross domestic product) into its banks, excluding asset guarantee schemes that had been provided to buyers of bailed out banks. Given that the Spanish Economy Ministry reports that Euro 184 billion in loans to developers are "problematic," the additional recapitalization needs of Spain's banks may be as high as Euro 200-300 billion in additional funds (20-30% of GDP).

Any European deposit guarantee system, provision of capital, or further funding of banks would potentially increase Germany's financial liability.

If integration is not undertaken or the partial solutions fail, then some European countries will need to restructure their debt and potentially leave the common currency. Germany would suffer immediate losses. A Greek default would result in losses to Germany of up to around Euro 90 billion. Germany's potential losses increase rapidly as more countries default or leave the eurozone. The greater the delay in default or departure the larger the German losses as their exposure increases.

In the absence of a Lazarus-like recovery in the peripheral economies, Germany's current exposures are not recoverable. If the present arrangements continue or there is greater integration, the increase in commitments or debt levels will absorb German savings, crippling the economy. If Germany wants to leave the euro reverting to the Deutschmark, it would suffer losses equivalent to its existing exposure as other European countries are unlikely to be able to settle their liabilities.

There are also real economic effects. Austerity or default will force many European economies into recession for a prolonged period. German exports will be affected given Europe is around 60% its market, including around 40% within the eurozone. In case of a breakup of the euro, estimates of German growth range from -1% to over -10%. It is worth remembering that the German economy fell in size by around 5% in 2008, the worst result since the World War II, mainly on the back of declining exports.

Defaults or partial breakup of the euro would also leave German banks with significant losses, potentially necessitating state support. This would further increase the state's liabilities.

In the case of integration or partial solutions, the effects on Germany may be cushioned by the weakness of the euro, which will maintain export competitiveness. But defaults and a breakup of the euro will result in an increase in the value of it, at least in the short term, undermining German exports.

Germany is being pressured to boost its own economic growth to assist the rest of Europe. This would force it to run budget deficits and increase its own debt. Higher wage rises would increase costs, undermining its international competitiveness. Higher consumption would also reduce the saving pool needed to finance itself, fund its banks and supply capital to the rest of Europe.

In the past, Germany has resisted efforts to incur fiscal deficits and increase domestic consumption to inflate the economy. The principles of thrift, prudence, a strong currency, and a distrust of finance, often associated with the Swabian hausfrau, are deeply embedded in the nation's DNA.

Germany's problems are likely to be compounded by a slow down in emerging markets. Recent German growth has relied on Asia, Eastern Europe, and Brazil. German carmaker Volkswagen (VLKAY) sell more cars in China than in Germany. Emerging market demand for high tech industrial machinery has helped German exports.

Germany negotiating position is weak. For example, Greece owes about Euro 400 billion to private bondholders but increasingly to public bodies, such as the IMF and ECB, mainly due to the bailouts. If Greece walks away as some political parties have threatened, then the fallout for the lenders, such as Germany, are potentially calamitous.

No positions in stocks mentioned.

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