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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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It's now about Germany, not about Greece, Spain, Italy, Ireland or Portugal.

Germany is financially vulnerable. Irrespective of the course of events, it faces crippling costs.

Germany may be too late to excise the gangrenous body parts of the eurozone.

Oh, What a Lovely Crisis

To date, Germany has had a very good European debt crisis.

The German economy is one of the few economies to have grown since 2008. Unemployment is low and workers have received pay raises.

Interest rates on its government bonds, bunds, are at a record low. The low rates reflect safe-haven buying as investors flee other European markets.

Politically, Germany's importance has never been greater. Chancellor Angela Merkel bestrides Europe as a female Bismarck (the German view) or a Gorgon (the Greek view).

Germany's success is based on an economy heavily rooted in manufacturing. It is also the result of Chancellor Gerhard Schröder's structural reforms, especially of the labor market. The recent 4.3% pay increase won by the influential IG Metal union is the largest since 1992. Interestingly, the union made little headway in the recent negotiations on the area of greater controls on contract labor, which companies use for flexibility and managing costs.

But a significant part of Germany's growth has been driven by the eurozone.

Favorable conversion exchange rates upon introduction of the euro artificially increased the purchasing power of countries like Italy, Spain, Portugal, and Greece. The common currency led to a dramatic fall in interest rates in weaker eurozone members as well as over time a compression of credit spreads.

No longer exposed to the risk of devaluations, a persistent feature of the post war economic history of Southern Europe, lenders lent generously to these countries. Debt fuelled consumption and investment drove growth.

German exporters were major beneficiaries of this growth. German banks and financial institutions helped finance the growth. It was the European version of 'Chimerica', where China financed American buyers of its products by lending back its trade surpluses.

German exporters also benefited from a cheap euro, receiving a significant subsidy because of the inclusion of weaker economies such Italy, Spain, Portugal, and Greece in the common currency. This cost advantage assisted German export performance, especially in emerging markets in Eastern Europe and Asia.

But the good times are ending.



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 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.



Doubling the Losses

In 1999, Finance Minister Theo Waigel proclaimed that the euro would be like the German Deutschemark it was replacing. In his book Fat Years: Why Germany Has a Brilliant Future (co-authored with journalist Dirk Heilmann), Waigel predicted that Germany would become the world's richest country as measured by income per head by 2030.

Now, the entire project faces an unimagined crisis. As Lorenzo Bini Smaghi, a former Italian ECB executive board member, observed: "The assumption was … that there would be no crises."

As anti-austerity parties gain support in the rest of Europe, German willingness to finance further bailouts is diminishing. Increasingly, Germans fear an unending commitment to preserve the common currency and the eurozone. The resentment is evident in a headline in the popular tabloid Bild: "Sell your islands, you bankrupt Greeks. And the Acropolis while you're at it." But it may be too late.

Germany's attempt to balance the benefits of the single currency and the advantages of preserving the eurozone against its traditional preference for fiscal and monetary conservatism has failed, leaving the nation with severe financial problems which will curtail future growth. The size of the exposure is large, both in relation to Germany's GDP of around Euro 2.5 trillion and German household assets which are estimated at Euro 4.7 trillion.

German citizens will have to pay twice for the euro.

In the early 2000s, they paid through internal devaluation – reductions in real wages, unemployment and labor market reforms. Now, they will have to pay for the bailouts. Once the artificial boom ends, voters will discover they were betrayed by Germany's pro-European political elite. There will be an electoral revolt and, as in the rest of Europe, a strong challenge from radical political forces with unpredictable consequences.

Germany's history is one of monumental reverses and extremes. In his 1901 novel Buddenbrooks, about a well-to-do North Germany family whose fortunes are in decline, Thomas Mann anticipated the present situation: "I know that the outwards, visible and tangible signs and symbols of happiness and achievement often only appear when in reality everything is already starting to go downhill again.The outer signs take time to arrive – like the light of a star which shines most brightly when it is on the way to being extinguished, or maybe has already gone out."

As Friedrich Nietzsche knew: "…hope is the worst of all evils, because it prolongs man's torments." Germany may not, as widely assumed, offer a safe haven in the European debt crisis.

No positions in stocks mentioned.

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