The ECB’s Financial Suttee

The European Commission is failing. Its response to Brexit and the pandemic, where it is now threatening emergency powers in order to secure vaccines is a latest throw of the political dice. Even before this development markets were getting the message with capital flight worsening.

The only thing that holds the Commission together is the magic money tree that is the ECB.

Following the recent change in the Commission’s leadership, the political dysfunction in Brussels is a new challenge for the ECB. It is already juggling with over indebted member states, a global rise in bond yields, a rotten settlement system and commercial banks both over-leveraged and with mounting pandemic-related bad debts.

It really is a horror show in the making.

Introduction

This week, the ECB took the next step towards its inevitable destruction of itself, its system and its currency. This ending, a sort of financial suttee where it joins the failing EU Commission on it funeral pyre, is plainly inevitable, and will increasingly be seen to be so.

On 3 March, Bloomberg reported “European Central Bank policy makers are downplaying concerns over rising bond yields, suggesting they can manage the risk to the euro-area economy with verbal interventions including a pledge to accelerate bond-buying if needed.” 

Then last week, the story changed: the ECB vowed that: “Based on a joint assessment of financing conditions and the inflation outlook, the Governing Council expects purchases under the PEPP over the next quarter to be conducted at a significantly higher pace than during the first months of this year”.

What had happened is that bond yields had started to rise, threatening to bankrupt the whole Eurozone network if the trend continued. That network is like a basket of rotten apples. It is the consequence not just of a flawed system, but of policies introduced to rescue Spain from soaring bond yields in 2012. That was when Mario Draghi, the ECB’s President said he was ready to do whatever it takes to save the euro, adding, “Believe me, it will be enough”. 

It was. The threat of intervention was enough to drive Spanish bond yields down and is probably behind the complacent thinking in the 3 March statement. But as the other bookend to Draghi’s promise to deploy bond purchasing programmes, Lagarde’s promised intervention is of necessity far larger. And there is the market problem, encapsulated in the saying, “fool me once, shame on you; fool me twice shame on me”. Does the ECB really think it is above this logic?

The euro started with the promise of being a far more stable currency replacement for national currencies, particularly the Italian lira, the Spanish peseta, the French franc, and the Greek drachma. The first president of the ECB, Wim Duisenberg, resigned halfway during his term to make way for Jean-Claude Trichet, who was a French statist from the École Nationale d’Administration and a career civil servant. His was a political appointment, promoted by the French on a mixture of nationalism and a determination to neutralise the sound money advocates in Germany.

From the outset, the ECB pursued inflationist policies. Unlike the Bundesbank which closely monitored the money supply and paid attention to little else, the ECB adopted a wide range of economic indicators, allowing it to shift its focus from money to employment, confidence polls, long-term interest rates, output measures and others, allowing a fully flexible attitude to money. Unlike the independent Bundesbank, the ECB is intensely political, masquerading as an independent institution. But there is now no question that its primary purpose is to ensure Eurozone governments’ profligate spending is always financed, “whatever it takes”. Our attention returns to the statement from the ECB this week, because rising bond yields threaten the ability of the ECB to finance in perpetuity increasing government deficits in the PIGS and France. Fool us once…

Business and money is beginning to leave

Traditionally, big business has loved big government. Not only is it a source of funds and preferences but it is an opportunity to lobby for regulations to the disadvantage of smaller competitors. In short, Brussels is the centre of European crony capitalism, which is why big business was set against Brexit. The CBI, representing big British industrial interests, lobbied hard to remain.

But since Brexit, the EU has advertised its own insecurity by waging a trade war against British imports, tying them up in needless bureaucracy. At the same time, the successful fast-tracking of the Oxford vaccine and its rapid deployment in the UK along with the Pfizer equivalent, compares with the abject failure of the Commission to roll them out across its member states, leading to a panicked reaction. On 27 January, officials raided AstraZeneca’s facility in Brussels, following production problems which had reduced the amount of its yet to be approved supply to the EU.

The message sent to all big businesses was clear. Investing in EU production facilities had become less attractive due to the implied threat to property rights. The Brussels lobbying game fundamentally changed for both European and international corporations. At the same time, the Commission attempted to move financial market clearing services out of London. The threat to freedom of capital flows in future became obvious to financial entities. According to HSBC, capital outflows reached €500bn in the fourth quarter of last year, representing an annualised pace of 20% of GDP, with half of it in December alone.

It is said that when you are in a hole you should stop digging. Not a bit of it: only yesterday, the Commission’s President threatened to invoke Article 122, allowing the EU to seize AstraZeneca’s factories and ban vaccine exports to the UK. There could hardly be a clearer threat to property rights for any multinational with offices and production facilities in Europe. Not only has the EU become a no-go for future industrial investment, but portfolio outflows seem sure to continue and accelerate further. And not only is the socialising Commission a failing organisation, but its downfall is becoming increasingly obvious for its member states to see.

The socialist ideal is coming unstuck

It is easy to not fully appreciate that the EU has turned into an intensely socialistic project, with a supranational commission overriding national governments, forcing them to conform to a centralised political ideal. Easy to forget, because the EU’s embedded socialism is almost never mentioned. Financially, it follows from redistribution policies whereby the majority of the Eurozone population is subsidised by savers in the Northern countries, centred on German’s savers.  

From 2000, Eurozone debt has risen from €5.2 trillion to €12.04 trillion in the third quarter of 2020, representing 97.3% of euro area GDP. Debt to GDP ratios are still soaring for two simple reasons: the EU economy is drifting into a deepening slump, and the important debtor nations of France and Italy have governments whose spending is already larger than their private sectors and other nations are getting close. 

According to the Statista website, French government expenditure is about 63% of the economy, leaving only 37% of the economy in productive private sector hands. And of that 37%, an unknown but significant portion is comprised of government entities which are off balance sheet. In Italy, government expenditure is 60% of GDP, leaving a bare 40% in the private sector to pay the taxes and service the debt. A high proportion of the private sector is insolvent, with non-performing loans hidden in the euro system.

Over the last year, the greatest debt to GDP increases were in Cyprus 22.9%, Italy 17.4%, Greece 17.3%, Spain 16.6% and France 16.5%. And as the pandemic enters its third wave, national finances are still deteriorating.

The most recent figures for all EU states are shown in Figure 1, extracted from Eurostat.

The damage done to the government finances of Greece, Italy, Portugal, Cyprus, Spain, France and Belgium by pandemic shutdowns has been substantial. The failure to distribute vaccines means that even on a best hopes’ basis, emerging from the crisis will face considerable delays with lockdowns likely to continue into next winter.

The damage the coronavirus has done around the world, even to relatively free markets, is unprecedented. Free markets can be expected to recover more rapidly with the virus’s passing than those dominated by the state. Where free markets are supressed and the profit motive despised by the general population, which is the case in socialistic countries such as France and Italy, recovery is likely to be very slow. Forget the mollifying words about economic growth in the future. Along with most of the Eurozone members, France and Italy require accelerating bond sales to balance the books which are deteriorating by the day. They are already deeply ensnared in a debt trap, it being impossible to fund mountainous government debt on such small tax bases. 

It is therefore no wonder that the ECB is sensitive to rising bond yields and that it is determined that they are kept as low as possible. The degree of suppression was illustrated yesterday, when a Greek 30-year bond sold out at a yield of 1.93% — half a per cent less than the US Treasury equivalent. It is plainly wrong for a country with a deteriorating government debt to GDP ratio of 200%, and with an appalling track record.

With the level of interest rate suppression this deal implies, even a moderate correction towards proper market pricing of bond yields threatens a systemic collapse of the whole euro system.

Why bond yields are rising

With the ECB firmly in control of financial markets, the inherent weaknesses and increasingly certain collapse of the euro system is for now generally ignored. Consequently, current troubles inflicting euro-denominated debt are more immediately associated with the sharp rise in dollar bond yields. Nevertheless, they share a common factor, which is that global markets are reassessing inflation prospects.

The official story, propagated by the financial establishment, is the following. As nations emerge from the coronavirus, business activity will return to normal. This outlook is guaranteed by the various stimulus packages and furlough support given to workers along with subsidies to businesses. And with consumers having been unable to spend more or less for a whole year, on the back of unleashed consumption the initial recovery will be strong. Consequently, there will be a temporary rise in prices which could exceed the 2% inflation target while pent up spending is absorbed. After that, conditions will return to normal, and the 2% inflation target will be achieved in the longer term without having to raise interest rates significantly. But even on this basis, one can see bond yields rising ahead of the increase in consumption. And the financial establishment is assuming that it is simply evidence of markets adjusting to the near-term inflation risk.

Even this Panglossian interpolation has the ECB panicking. The panic confirms that for the ECB there is no planned exit from its negative deposit rates, because with a post-covid recovery, some government finances at a national level cannot absorb any increase in bond financing costs at all.

Let us now consider a more realistic outcome, shorn of establishment wishful thinking. As mentioned above, it is likely that pandemic lockdowns throughout Europe will continue for much, if not all of this year. Consequently, on a best-case basis, economic recovery will badly lag that of the rest of the developed world. We have noted the debt traps already sprung on major EU nations by the pandemic and can readily conclude that the centralised government funding system being managed by the ECB will run into existential difficulties. But so far, we have not challenged the assumption that after lockdowns normality of a sort will return.

Even if normality does return in other major economies, the Eurozone’s banking system is preoccupied with funding national debts and dealing with non-performing loans. And being on average much more highly leveraged than the US banks, eurozone commercial banks are unable to expand the bank credit upon which economic recovery depends. But having already been damaged by the ending of the global bank credit cycle’s expansionary phase and the malign effects of a tariff war between the US and China, the global economic outlook has significantly worsened from the beginning of 2020 — only to be concealed by the pandemic crisis and the inflationary responses to it.

Not only is the Eurozone’s banking system unable to provide new credit for businesses, nor can the US banking system do so for its more dynamic economy. The reference to the bank credit cycle is not made lightly, because bankers now find that their balance sheets are at their most stretched — even beyond regulatory limits. They are being hit by widespread bankruptcies. American bank lending to the private sector is rapidly becoming a disaster as losses from non-performing loans are magnified by balance sheet leverage at the equity level, averaging 10.5 times for the big banks. So not only is the new Biden administration faced with financing a recovery from the coronavirus, but it might have to shore up the entire US economy from a cyclical depression whose driving factors are similar to those of the early 1930s.

The mounting evidence of this outcome has implications for global interest rates. A text-book Keynesian economist viewing consumer demand as the economic driver believes that a depression means lower interest rates, which is why he is confident that rising bond yields herald a more positive economic future. The error is to not understand that in a depression both consumption and production contract. And being more forward looking, producers will reduce capacity when they see the outlook deteriorating ahead of reductions in consumer spending. That being the case, monetary stimulation into a failing economy quickly ends up undermining the purchasing power of its fiat currency, instead of increasing it and threatening deflation, as a Keynesian analysis might suppose. 

For the possessor of a fiat currency, there comes a growing realisation that its purchasing power will fall, whatever the economic outcome. If, as we are to suppose, the risk of a negative economic outcome increases, then the debasement will only escalate. To compensate, the offset in the form of interest paid on his monetary capital must increase if currency balances are to be maintained, reflected in higher interest rates and bond yields. 

The crucial point is that our currency holder’s understanding of the outcome of inflationary central bank policies is markedly different from that of the policy planners. And even if Mr Pangloss at the Fed or the ECB is right, then the purchasing power of dollars or euros will fall anyway and those who possess it will still expect higher interest compensation to justify holding on to them. Alternatively, if the owner of a fiat currency concludes that accelerated monetary inflation will not save the economy from a slump, then because it is unbacked and not convertible into a sounder form of money, he will abandon it altogether.

The evidence of the loss of purchasing power for fiat currencies is already visible in commodity prices, shown in Figure 2.

After a decade of consolidation, which ended in March 2020 with a dip down to 83.97, the IMF’s index has risen 67% in eleven months to 140.65. The turning point was the Fed cutting its funds rate to zero and increasing QE to $120bn per month in March 2020. Clearly, the commodity markets responded by discounting increased monetary inflation. Commodity prices in euros rose less due to the rise in its rate against the dollar, but that rise is still a substantial 55%. For genuine industrial users, keeping their excess liquidity in dollars or euros and to have not reduced currency ownership has been a costly error.

While macroeconomic commentators view the swings in commodity prices as cyclical, a more relevant interpretation is provided by understanding their users’ point of view. For manufacturers it is simple: the purchasing power of a currency measured against commodities has declined, in the case of the euro by over a third. And with monetary inflation increasing, it is a trend certain to continue, having little or nothing to do with levels of commodity demand.

Commodities are one of several economic inputs. Labour is another. And if a manufacturer is not competitive, the sensible recourse is to increase investment in automation, which requires monetary capital. The circulating element is provided by the banks, but as we have seen banks are now maxed out, risk averse, and in the eurozone fully committed to funding governments. For the eurozone banks there is an additional problem. Their balance sheets are weighted towards assets designated by the regulators as risk free or very low risk, such as government bills and bonds. An allocation into industrial and consumer lending carries extra risk, necessitating a reduction in balance sheet gearing. It is not going to happen easily or willingly.

Target 2 imbalances

Figure 3 illustrates the imbalances in the TARGET2 settlement system between the national central banks and between them and the ECB. It reveals three features. Germany and Luxembourg between them are owed a net €1.3 trillion. Italy and Spain between them owe the system €968bn. And the ECB owes the national central banks €345bn. The effect of the ECB deficit, which arises from bond purchases conducted on its behalf by the national central banks, is to artificially reduce the TARGET2 balances of debtors and creditors in the system to the extent the ECB has bought their government bonds. 

After allowing for the ECB’s bond purchases, the combined debts of Italy and Spain to the other national central banks easily exceed €1 trillion, and the money owed to Germany’s Bundesbank is greater than the chart shows by the extent of German debt bought by the Bundesbank on the ECB’s behalf and unpaid. The ECB’s dealings also affect France’s balance, which last March stood at a deficit of €109.4bn compared with a surplus of €40bn in January, which can only be due to payments by the ECB for French bonds, window dressing France’s position.

In theory, these imbalances should not exist. The fact that they do and that from 2015 they have been increasing is due partly to accumulating bad debts, particularly in Portugal, Italy, Greece and Spain. Local regulators are incentivised to declare non-performing bank loans as performing, so that they can be used as collateral for repurchase agreements with the local central bank. This has the effect of reducing non-performing loans at the national level, encouraging the view that there is no bad debt problem. But the problem has merely been removed from national banking systems and lost in the euro system.

Demand for collateral against which to obtain liquidity has led to significant monetary expansion, with the repo market acting not as a marginal liquidity provider as is the case in other banking systems, but as an accumulating supply of raw money. This is shown in Figure 4, which is the result of a survey of 58 leading institutions in the euro system.

The total for this form of short-term financing grew to €8.31 trillion in outstanding contracts by December 2019. The collateral includes everything from government bonds and bills to pre-packaged national commercial bank debt. According to the survey, double counting, whereby repos are offset by reverse repos, is minimal. This is important when one considers that a reverse repo is the other side of a repo, so that with repos being additional to the reverse repos recorded, the sum of the two is a valid measure of the size of the market outstanding. The value of repos transacted with central banks as part of official monetary policy operations are not included in the survey and continue to be “very substantial”. But repos with central banks in the ordinary course of financing are included.

Today, even excluding central bank repos connected with monetary policy operations, this figure probably exceeds €10 trillion, taking into account the underlying growth in this market, and when one includes participants beyond the 58 dealers in the survey.

While the US Fed only accepts very high-quality securities as repo collateral, with the eurozone national banks and the ECB almost anything is accepted — it had to be when Greece was bailed out. High quality debt represents most of the repo collateral, but the hidden bailouts of Italian banks by taking dodgy loans off their books could not continue to this day without them being posted as repo collateral rolled into the TARGET2 system. 

But there is a limit to this expansion, expressed in the relationship between a commercial bank’s capital and its equity. Figure 5 shows balance sheet gearing and shareholder leverage for the six listed Eurozone global systemically important banks (G-SIBs). Other eurozone banks do not have to carry the extra buffers to a G-SIB’s capital, and it is for sure that within their numbers there are even more highly leveraged banks, the failure of any one of which could lead to a system-wide run.

Without exception, the balance sheet gearing between total assets and shareholder’s tier-1 equity of all these banks is very high, given that a more normal level of balance sheet gearing is in the region of eight to twelve times at the height of a bank’s credit expansion cycle. It compares with the average ratio for the six US G-SIBs of 10.5, and even they are demonstrably tight on balance sheet capacity. 

Market ratings for eurozone G-SIBs, with the arguable exception of ING, deeply discount shareholders’ equity, with Société Generale bearing the worst rating at a 71% discount. Moreover, these dismal ratings are at a time of buoyant stock markets near their all-time highs: the CAC 40 in Paris is up 60% over a year, the Dax in Frankfurt is up 73%, and the FTSE MIB in Milan up 64%. Like a party of drunks staggering to raise themselves from the gutter, Eurozone bank share prices have risen with the general markets, but it is their ratings which remain so appalling.

Conclusions

The EU is showing all the signs of a failing state, embarrassingly exposed by Brexit and the EU’s political response. Politically, it is still prepared to cut off its nose despite its face, clearly demonstrated over the vaccine debacle, aimed at the Oxford based AstraZeneca vaccine as a cover-up for the failure of Brussels to source and distribute vaccines of any manufacture around the member states. At a time of emerging lockdowns in the rest of the world, the EU is badly behind in its vaccination programme and is unlikely to fully emerge from its lockdowns before next winter, and possibly beyond. The economic consequences for the EU are going to be more devastating than for any other region outside the developing world, with third waves now emerging in Italy, France, Germany and Poland.

With the burden of financing the inevitable surge in covid-related bad debts, particularly in the PIGS but really everywhere, and with major EU nations’ national debts spiralling out of control, the financing of it all by the ECB will become increasingly difficult. As a central bank committed to financing socialising ideals by monetary inflation, the ECB has had no option but to accelerate its inflationary financing for some time. But today, the limitations placed on its inflationism are a lethal combination of the inherent rottenness of TARGET2 and rising bond yields.

Even on an optimistic (Keynesian) analysis, rising bond yields appear to be discounting a rise in post-lockdown spending, leading to a temporary burst in price inflation. The deeper truth revealed by the performance of commodity markets combined with an unprecedented increase in global money supply is that a far deeper loss of purchasing power in fiat currencies is in prospect. Furthermore, optimism over the wider economic outlook is confined to inflated numbers, with large sections of the global economy in a state of collapse.

The EU is a tail-end Charlie in this global environment, which is why it could not afford to mess up its emergence from pandemic lockdowns. And because the financing of it all falls on the ECB’s shoulders, that is where the EU’s crisis is sure to emerge. It will take out the banking system for sure; on slender equity bases, it will not take much of a rise in bond yields to wipe them out. And then all that ropey collateral in the repo system will be exposed for what it’s worth. Which is mostly nothing.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

 Twitter: @MacleodFinance

MOBILE: +44 7790 419403

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