Emanuel Arbib

Pending the unloading of the real bazooka that the market has been expecting from Angela Merkel, the ECB has decided to fight for time by propping up the banks through the LTRO. This course of action displaces private activity and is producing several distortions. Let’s look at a few of the most significant ones. Firstly, together with the stated QE policy of the Fed and the BOE, it is keeping short rates (and in the US and UK also long rates) very low, amidst a torrent of liquidity. However, the chain of transmission has stopped working, and these banks are not passing on their cheap funding to corporate clients. They are doing two things with the ECB funds; either they hoard it for fears of rainy days, or they use the funds to invest in government bonds that yield many hundreds of basis points more than their funding, even for short term issues, thus pocketing a substantial spread. The problem with this seemingly simple strategy is that if any of these governments were to default or restructure, they would be compounding their problems, given that the very problem that most of these banks are tackling is the high proportion of government bets among their assets.

Following on the tradition of previous EU summits, last week’s event proved to be a letdown for those who have been hoping for the Germans and the ECB to start working on an effective solution that would give immediate gratification to the financial markets. What they got instead was a roadmap to a political long term solution based on a moderate relinquishment of sovereignty to ensure that failure to abide by the budget rules would have ‘automatic’ consequences. The problem is that such an outcome would have been great nine, six, and maybe even three months ago, but with today’s degree of scepticism, it is far from clear that these political horizons will satisfy anybody, let alone the markets, which indeed reacted negatively.

No wonder that Cameron chose to use the veto red button that is meant to be there for leverage not to be actually used. By using the veto Cameron has basically lost the leverage. Just like the US Republicans have found lawyerly ways to go around the automatic government expense reduction agreement to protect for example, defence, the EU, with Sarkozy’s leadership, will find crafty ways to go around the UK veto while at the same time marginalising his British cousins. But Cameron thought that if there is a time to be wary of more Europe, it is now! Who wants to jump into a sinking ship? This is not a good sign…

Just as we discussed last week, Monti has delivered a tough but fair budget which comprises both tax savings and incentives (the deductibility of the horrible IRAP tax is certainly welcome and long overdue). Has he done enough? Probably not, but in only just over a couple of weeks in office, this can be considered a very serious achievement.

Interestingly, Monti has described his Emergency Budget as a Save Italy bill. While Monti couldn’t say it given that he needs their votes, the last famous times that parliament voted save-something bills was to save Berlusconi’s TVs from being put off the air.  This time, Monti said, we need to save Italy, and indirectly, the entire Euro endeavour. Will it do the job? Well, the markets clearly liked it a lot, sending the infamous BTP-Bund spread well below 400bps from a high of nearly 550bp four weeks ago.

But the ball is now back with Sarkozy and Merkel, and later on this week with the other Euro zone members, who will need to show Draghi that they have done all they can on the political front and give him a green light to use the Bazooka, given that, this must be made clear, he is the only one who has the technical means to execute instantaneously. The method is probably the one we have discussed before: a SSB  style statement saying that the ECB will not tolerate yields on certain government bonds to trade above a stated limit.

We would like to add one caveat to this. While the SSB’s methods have worked brilliantly, and just the announcement worked its magic, Draghi knows that at this late stage in the crisis he must be ready to confront the market for real if he is tested. This test will probably come at some later stage, when some hiccups will start emerging on the political front. Let us hope that this weekend will see serious and actionable decisions.

The standard narrative in Italy is that the advent of the Euro saved the Italian economy. Three standard reasons are given: the Lira kept on being targeted by speculators and its peg to the ECU and DM had to be devalued on a semi-regular basis; the conditions for joining the club, which were imposed by the Prodi-Amato administration forced Italian finances to become more virtuous; and finally, the lower cost of borrowing would have allowed the budget deficit and the cost of servicing the stock of debt much lower.

Most of the above benefits did indeed take place for most of the previous decade, which saw record low borrowing rates, primary budget surpluses, and a conservative approach to government spending post the Lehman crisis which meant that Italian finances didn’t appreciably deteriorate after 2008, unlike the United States’ and the UK’s, for example.

However,  and counter intuitively, the price paid for these virtues was a transfer of wealth from the productive areas of society which stopped growing as unit labour costs went up in absolute and relative terms and made Italy less competitive, to the ‘rentiers’, which had lower nominal returns on their fixed income portfolios, but enjoyed an incredible appreciation in the value of their real assets. These effects are easily spotted: Italy barely grew in the last decade, as a strong currency made it less competitive vis a vis not only China, but also Germany, but the price of a square meter of prime real estate in Rome and Milan is now in the same league of London and Paris, and certainly higher than Frankfurt and Berlin.

The fair way to deal with this problem, which we understand Mr. Monti  ‘gets’, is to reduce taxation on the productive part of the economy, by lowering payroll taxes, and making the labour market more flexible, and at the same time taxing big property wealth and increasing the pensionable age. These measures would have a combined effect of reducing youth unemployment, reducing unit labour costs, increasing consumption, and ensuring a degree of fairness to the fiscal adjustment which will improve the chances of it being accepted by the nation.

It was pleasing the notice the stark difference in the treatment offered to M. Monti from Mr. Sarkozi and Ms. Merkel, as opposed to how the two of them made Berlusconi a laughingstock, only a few weeks ago. In yesterday’s three nation reunion, the continent’s top three economies made a show of unity, even as not much substance was disclosed.

The bottom line continues to be that, having been burnt by Greece and Italy already, Frankfurt and Berlin will only capitulate on the issues of QE and/or Eurobonds, at the very last minute. We have two observations/analogies to make.

The first one is that the European and world leaders are keenly aware that this train is headed towards a big wall, and they must deviate it pretty quickly, and that there are few alternative routes and not much time before the sheer speed will make it difficult to call if it is not too late to make the change.

The second is that we read yesterday that Germany has bought a first class ticket on the Titanic. This is an apt comparison. Germany is betting that by delaying to the last possible minute the inevitable decisions, it will ensure that the profligate southern Europeans will execute on their promises this time rather than just doing lip service. The problem is that with regards to Italy at least, even with Monti at the helm, Germany doesn’t trust parliament to vote for his measures, given that Berlusconi can ‘switch Monti off at any time,’ as someone attributed to Berlusconi.

Basically, we probably have good pilots driving our Formula One, but the terrain is wet, the track is tricky, and visibility is decreasing…Let’s hope that they know what they are doing.

After requesting, and obtaining, the heads of the three Prime Ministers of Greece, Italy, and Spain, the markets do not appear at all satisfied with the simple notion of change. As we discussed last week, the cure that would have done the trick a few months ago, is now treated as ‘probably too little, certainly very late.’

What is happening now is that the markets will continue to test the new weak link, with France in the sights of the markets because of the exposure of its banks, until, probably a minute before it is too late—if we are lucky—mighty Angela Merkel will save the day.

There are essentially three scenarios ahead of us. The best case scenario is that possibly through a joint intervention of the IMF (led by an experienced French lady…), Mario Draghi will get Merkel’s green light to effectively become the banker of last resort to the troubled European states. This may happen either, as we discussed previously, through a clear statement that the ECB will do all it takes to keep a lid of yields, just like the SNB has effectively done with the Swiss Franc, or via an intervention of the IMF co-financed or co sponsored by the ECB, or by Germany agreeing to the ‘euro-bond.’ It is unlikely at this late stage that anything other than clear, concerted action with the clear backing of Germany will work.

The second possible scenario entails the breakup of Germany, and possibly the other strong euro members, from the Euro. This would leave the euro as a weaker common currency shared by the eastern and club med countries of Europe.

The final scenario, probably the most disruptive, is a complete breakup of the euro, which could be triggered by Spain, Italy, or even France.

Both latter scenarios would be caused by Germany being too scared, for historical reasons, to take the political lead of the continent, which is what would effectively happen if it became the main lender of last resort, or the underwriter of the euro bonds. Leaders sometime have to take tough decisions, and Germany is too worried of the negative sentiment that could be engendered by it starting to effectively dominate the continent again, this time through its Teutonic credit rating, rather than by its military might.

During the weekend before Lehman failed, its general counsel quietly asked outside lawyers to prepare for a filing, just in case. He obviously did it very quietly, as the sheer notion that bankruptcy was even an option being considered would have thrown the whole industry into chaos. At the time feverish negotiations with the government and competitors were taking place and most pundits were expecting a Fed led takeover, a la Bear Stearns. Unfortunately, Sunday night and Monday morning the draft filing was made formal and it was indeed filed on that fateful September, 15 2008.

In the last few days I have started receiving emails and calls about how a euro breakup would play out, from a legal standpoint…which bonds would be repaid in Drachmas or Lire, which in the surviving euro currency, etc. This kind of preparation is the equivalent to calling the bankruptcy lawyers, just in case, except that since the Euro is not controlled by one single entity but by seventeen European governments, the chance of this staying quiet is virtually nil.

The markets now know or speculate that governments, creditors, and debtors have hired top London and New York lawyers to advise them on the legal ramifications of a Euro breakup. This is both a good and a bad thing. It’s bad because the sheer speculation that things are at this point will make markets continue to bet against all non German Issuers; however, it is good as the market knows that when and if that day comes, the logistics would have been worked out before and the panic could be less severe. Is this what the Germans want?

Mario Monti, Italy’s new prime minister was the professor we all wanted to listen to and the one we tried to avoid at exam sessions. He is brilliant and very serious, and paradoxically, the inverse personality type compared to his immediate predecessor, Mr. Berlusconi. The task Mr.Monti has in front of him is also very serious and daunting.

Italy’s problems, and its potential are not new, and the recipes needed to fix them are also generally known to many. The new facts are that, as every trader knows, once you start breaking through historic support levels, coming back up is not going to be easy. An equilibrium was broken and even if the situation were to revert to what it was ex ante, the markets will not return to normalcy until there is either: a. A confirmation of a long period of budgetary prudence that credibly brings debt/GDP ratios towards and eventually below 100%; or b. A bazooka from the European Central Bank (ECB).

This scenario is clearly being confirmed by this week’s market action. After a brief relief rally that didn’t even last a day, markets are edging back to their lows. Given that Monti’s appointment and new government are not going to fix the problem quickly, the attention will shift squarely back to the other Mario, that by one of the ironies of history, is now sitting at the top of the ECB. This is because what Mr. Monti’s government does do immediately, is provide much needed credibility for the other actor who could theoretically solve the problem in half an hour.

Many pundits believe that the tug of war that took place last week was between Draghi and Berlusconi. When in August the ECB started buying Italian BTPs it was on the basis that Berlusconi would deliver on the ECB requests. As Berlusconi dilly dallied, partly because of his own issues, but also due to the Lega Nord’s veto on pension reforms, Draghi who in the meantime was just adjusting his chair to Trichet’s desk, had to play brinksmanship and made it clear to Berlusconi that no reforms meant no more bond buying, or a trickle of purchases. Draghi won that battle and with one veiled threat succeeded in a few days to remove the leader who has faced dozens of prosecutors, courts, and the Italian people many times, and survived.

If this thinking is right, then having won that round, Draghi now needs to face that he got what he asked for. He now needs to pull out his bazooka, which financially today means doing to BTPs (but also possibly soon to OATs) what the Swiss National Bank did to stop Swiss franc speculation; namely, to say that the ECB will not tolerate yields above, say 6%. At this late point in the European debt saga, I am afraid that nothing short of this will work. This decisive ECB action would give Monti and his team the minimum time necessary to deliver on structural reforms, and it would have the added benefit to scare Berlusconi, the League, but also the Left, that if they don’t stay the course, Mario Draghi can also reverse his.