Europe: Review

Liquidity Risk

The ECB has removed liquidity risk; this should continue as long as the ECB eventually commits to money printing (which they will inevitably have to do).  2 LTRO's and the specter for more, relaxed collateral requirements for repos, and emergency lending to "solvent" banks has removed liquidity risk for sovereigns and their banks, but has come at the increased the risk of loss on the ECB and creditor nations (e.g., Germany) under TARGET2. 

Now, the ECB seems willing to buy 2 year and shorter debt of Italy and Spain, provided they accept an MOU.  Anyways, the decision to pile on the risk of loss in case of an exit/breakup would not have been made lightly; there has been incredible resistance from Germany, in particular the Bundesbank, so the doubling down shows Germany's resolve to maintain the Euro as a whole (if they do what they say). 

2 year Euro Swap Spread

3 month Euro basis swap

One question that must be asked is: if the ECB could - without exceeding its mandate - buy the short end of the yield curve to maintain the monetary policy transmission mechanism, then why didn't they do this with Greece, Ireland or Portugal?  And if they're concerned about the transmission mechanism for monetary policy, what does acceptance of an MOU under the EFSF/ESM have to do with anything?  Is this solely (as Draghi hinted) about removing the risk of a euro breakup?  Does that mean the ECB sees itself as a de facto lender of last resort to sovereigns?

So, Europe will have the EFSF/ESM buying bonds in the primary market, and the ECB buying them in the secondary.  I don't see how this is anything other than a sneaky way to monetize peripheral debt: the EFSF/ESM buys the bonds at auction, then sells them to the ECB in the secondary market (or are they going to sterilize, as under the SMP?).  That  may not be a technical violation of the ECB's mandate, but its effect surely is beyond the scope of its legal authority.  Under the SMP, the ECB had cover to buy peripheral debt because they sterilized their purchases.  Should Italy and Spain need a bailout, the sums would be too great to sterilize; the ECB will have to monetize (outside of its mandate) or will have to capitulate.

Its hard to imagine that a Spanish bailout won't require Italy to get one as well.  As such, it will fall on the ECB to monetize debt in order to keep Spain and Italy afloat; the EFSF/ESM doesn't have enough for both, even with the involvement of the IMF.  Oh, and of course Spain and Italy have said they will not need to take any bailout funds, just like Greece, Ireland, Portugal, and Spain (bank recap) said just before they did.  Further, its been reported that Spain has stated it will never take a bailout that includes more conditions than the ones imposed by bank recap package.

Finally, its possible the ECB would have to buy enormous amounts of Spanish and Italian debt once they start.  The Economist asks, "how, precisely, Mr. Draghi proposes to make good his commitment to address investors’ fear that a big intervention by the ECB would downgrade the bonds held by others. Experience shows that, when Greece’s debt was restructured earlier this year, the ECB insisted on its bonds being treated as senior. The ECB took no losses, while private bondholders took a 70% hit. "  

Solvency Risk

The real issue that has not gone away (nor will by monetary policy alone) is solvency risk, of both sovereigns and banks.  I'm going to focus mostly on Spain and Italy, as their fate will determine that of the euro.  They both face high debts and high deficits, with little prospect for economic growth in the near term.  The market is concerned that they are in a debt trap and will eventually have to write down most of their debt, which could then cause solvency problems for their domestic banks (and foreign ones).  The problem is mostly the trend - things are bad, but they're also heading in the wrong direction.  Europe is running out of time to convince markets it can balance budgets and create economic growth.

Spain

• Debt:
• Spain's official debt to GDP at the end of 2011 was 68.5%.  Add 2012's deficit (currently projected at 6.3%, which is too optimistic), then subtract the 2012 economic contraction (1.7% by the IMF's projection, again, likely too optimistic), and you get a Debt/GDP ratio for Spain of at least 77%.  Then add the €100 bn to recapitalize the banks, and you get 86%.  This does not include debt of the provinces (such as Valencia) that the national government may likely have to take on, and there is no end in sight to recession and deficits.  Further, because debt is reaching 100% of GDP, debt/GDP will continue to grow even during economic growth if the interest paid by Spain is higher than its GDP growth.  (See also, Mark Grant via Zerohedge.com, calculating Spain's Debt/GDP at 146%).
• Deficits:
• Will likely be 7% in 2012 and not too far from it in 2013, without further budget cuts and tax increases or economic growth (despite the hopetomistic view of Spain, et. al., growth next year won't be much better than this).  No end in sight to mid single-digit deficits.
• From The Economist: "The Spanish government must borrow €385 billion until the end of 2014 to cover its budget deficit and other needs such as bond redemptions, according to economists at Credit Suisse. Even if the IMF chips in a third as in previous bail-outs, European lenders would have to find €250 billion or so. They have already committed €100 billion to rescuing Spanish banks, so for other emergencies they would have only €150 billion of the €500 billion now in their rescue kitties."
• Budget:
• I'm going to save most of the writing talking about Italy's hilarious expenditures.  Given their similarity, I'm assuming Spain has the same nonsense they could cut, but won't.
• Economic Growth:
• The trend is still downward.
• Ongoing deleveraging by Spain, the regions, the banks, and the public
• Complicated by capital flight
• From The Economist: "Spain ran hefty current-account deficits in the first decade of the euro. As a result, its liabilities to foreign investors exceeded the assets that its residents own abroad by 92% of GDP last year, among the highest in the euro area. The problem for Spain is that foreign capital has been fleeing over the past year. That has weakened the banks and the economy and left the Spanish government shunned by foreign investors for its own financing needs."
• From Reuters:  "Capital flight from Spain gathered pace in May and the central government deficit rose further above target in June, taking the country two steps closer to the full-scale bailout it is desperate to avoid.  Outflows rose to 41.3 billion euros ($50.6 billion) as the government's rescue of one its biggest banks hit already fragile investor confidence and triggered a plea for European aid worth up to 100 billion euros for the country's lenders.  In all, 163 billion euros - or around 16 percent of economic output - left Spain between January and May, with domestic banks sending money abroad, foreign lenders pulling out cash and mostly non-resident investors dumping domestic assets.  Over the last 11 months, funds equivalent to 26 percent of GDP exited the country, Tuesday's data from the Bank of Spain showed."Labor/employment rigidity
• Bureaucracy
• Lack of competitiveness
• Real estate market decline
• Largest loss of companies in Spain are real estate-related (as much as 15% fewer in 2011 alone): "Number of firms operating in Spain hits 5-year low"
• Unemployment
• About 25% and rising.  Is work being done off the books?  Its hard to imagine their economy being as stable as it is (it should be imploding) if unemployment was really that high.  Even if that's the case, it still means no income tax revenue for the state.

Italy

• Debt:
• Italy's official debt/GDP at the end of 2011 was 120%.   Add 2012's deficit (currently projected at 2.4%, which is too optimistic), then subtract the 2012 economic contraction (1.2% by the IMF's projection, again, likely too optimistic; 2.4% according to business lobby group Confindustria), and you get a Debt/GDP ratio for Spain of at least 125%.  Again, with debt so high, you have to have growth above the interest paid by Italy to keep the ratio from increasing, let alone reducing it.
• Deficits:
• Supposed to be 1.7% of GDP in 2012 and .5% in 2013, but again, those are rosy assumptions.
• Budget:
• Gems like these are why the market worries that nothing will change:
• Italy pays more than any other country to Olympics medal winners.  $182,400 for a gold.
• The average Italian politician's salary is the highest in Europe, at  €180,000 a year.
• Italian politicians also enjoy numerous expensive perks: total spending on private cars and chauffeurs alone is about €4 billion per year.
• I don't feel like looking more up, these were the easiest to find, but you get the idea
• Economic Growth
• The trend is still downward.
• Deleveraging, capital flight, similar to Spain - See WSJ
• The rest is the same as Spain, except northern Italy is doing ok (industry is located there), so overall Italian unemployment is "only" at 10.8%.