Euro Bonds – “not in my lifetime” – Mrs Merkel

As usual, everyone has just one issue – what’s happening in the EZ.

Well Mrs Merkel’s “not in my lifetime” speech rejecting Euro Bonds is the headline grabbing all the attention today. Personally, its a load of old nonsense.The EZ will have Euro Bonds in due course and, in my opinion, much sooner than people think. However, Mrs Merkel wants political union, with fiscal and banking union, before agreeing to Euro Bonds. I also believe that she understands that there will have to be a transfer union – after all Germany has one (Bremen and Berlin are constantly bailed out) and, recently, agreed to fiscal union with German States ie the States can raise debt (presumably with oversight), based on Germany’s credit rating. In addition, she understands the need for structural (including labour) reforms in Europe, which is clearly very much needed. Essentially, she believes that growth has to be generated internally in each EZ country – a bit (OK, very) optimistic. However, you cant blame her for her views though. The ludicrous compromises, deals and fudges of the past have got the EZ to where it is at present. Indeed, Germany and France were amongst the 1st to breach the EU rules in terms of limiting budget deficits to just 3.0% of GDP. Essentially Mrs Merkel is playing “don’t let a crisis go to waste” game and she believes that market pressure will force (much needed) reforms. She’s also doing a Mrs Thatcher. A number are predicting a collapse of the Euro/EZ – personally, I don’t think so.

I had expected some movement at the EU heads of state meeting on the 28/29th June. However, it looks as if there will be no material policy actions coming out of the summit. Yes Spain may get funds from the EFSF and therefore not have a problem with the subordination of existing private sector bond holders and there is an outside chance of the EZ bail out funds being injected directly into Spanish banks (as long as Spain agrees to oversight – which clearly they will have to), which will not, as a result, increase debt to GDP to around 90% by the year end – will be some 10 percentage points lower at around 80%. However, the bottom line is that Spain cannot continue to finance itself at current rates (indeed can Italy) and will require a full bail out in the next few months. In addition, the E100bn earmarked for Spanish banks is totally insufficient – the Spanish cannot get away from fiddling the books. The current EZ bail out funds (the EFSF and the ESM) are inadequate in terms of firepower (indeed, the current expectations of the ESM having E500bn of funds must be questionable, as a number of countries which have been and will need a bail out are expected to contribute !!!), which suggests that the ESM will have to be granted a banking licence in due course. The ECB may be persuaded to buy peripheral debt, but this is no long term, indeed even a medium term solution. Ultimately the solution will have to be higher inflation in the EZ – indeed, even the German’s (the finance minister) expects it. QE is inevitable, basically.

Italy, well Mr Monti is in trouble politically. There were strong rumours yesterday that he was thinking of/threatening to resign. Mr Berlusconi has called for Germany to exit the Euro. Germany leaving the Euro is not an option in my opinion. Its currency will become a super charged Swissy, wrecking its manufacturing/production and export business, which is close to 50% of its GDP. In addition, I cant see Finland, Austria or Holland (Germany’s traditional allies) wanting an extremely strong currency, if they were to join Germany. However, the thought of Mr (“bunga bunga party man”) Mr Berlusconi returning must alarm all in the EZ, including Mrs Merkel.

Mrs Merkel is keen for market pressures to force the necessary changes on countries in the EZ. As I wrote yesterday, she also believes that Europe (even Germany) cannot compete with the China’s and India’s and an US block in the future and needs to unite politically. She is gung ho for political union, which will clearly involve fiscal and banking union. A total restructuring of the EU bureaucracy in Brussels will be necessary as well, with elected politicians in charge (Mrs Merkel as the 1st European President?). Opening up Germany’s cheque book (which is not unlimited) will follow, but effectively only after fiscal, banking and political union.

By the way, Germany’s position on banking union is somewhat disingenuous. Germany is demanding oversight of banks in other EZ countries, but will not include their domestic Landesbanks. The reason, is because the Landesbanks are seriously under capitalised and, guess what, will need to be bailed out – will not go down well politically in Germany. The German’s hate bankers, probably even more that than some EZ countries.

Mrs Merkel is also mindful of domestic public opinion. After all, she has elections late next year. The good news (from her point of view) is that the opposition is keener on Euro Bonds (which the German public are increasingly wary of) and her comments of “not in my lifetime” plays well with the German public, ie the voters. However, its not all one way traffic. The Kiel institute slashed Germany’s growth forecasts by 50%, to closer to 1,.0% for 2013. Personally, I believe that even this forecast is optimistic. If Germany’s opposition can convince the German voters that the downturn (which whatever my German friends tell me is coming – they believe not) in Germany is due to Mrs Merkel’s economic policies, well………

The key country remains France. The French designed the EU as a confederation of European States and are totally opposed to a supranational organisation ie political union – in other words an United States of Europe. In addition, they have parked their people in a number of the most influential positions in the EU and (all) EU heads of State have elected weak (some would say incompetent) leaders, as they pose the least trouble to them. In addition, Germany is becoming Euro sceptic, very much like the UK, but German politicians are not – they want a fully fledged political union.

You cannot fault Mrs M’s logic, but will the German plan play out as they expect. History suggests that it wont. The late 2013 German elections suggests to me that Mrs M will have to sort this out by Spring next year. A further delay and or continued uncertainty will (politically) be bad news for Germany ie Mrs Merkel.

I believe that kicking and screaming Hollande will agree to political union – however can he sell it to his colleagues/France?. The French are known to take to the streets – could well happen. Political union stands a better chance with Hollande in power – Sarkozy would have fought it tooth and nail. In addition, Monsieur Hollande needs to perform an U turn, in respect of all the ludicrous promises he made as part of his election campaign. Certainly no easy task

However, France remains the key – if they concede on the political union issue and can bring along their countrymen, I believe you will see a new Mrs Merkel. The current wishy washy plan prepared by the EU bureaucrats is a joke – a waste of the tons of paper they will use to circulate it to all and sundry.

My view is that not a great deal will come out of the 28/29th meeting, though I hope I’m wrong. The only good thing is that market expectations are low, indeed at rock bottom. However, as the failure sinks in, markets could well react negatively. The ECB will have to act, presumably with a 25bps interest rate cut (at least, though possibly a 50bps) on the 5th July, together with a (possible) reduction in deposit rates, from the 25bps currently, to zero, in an attempt to stop banks depositing money with it and lend instead. Initially, I believe that fear will prevail and banks will continue to park money at the ECB, but in due course will start lending. EZ inflation is declining fast – today’s June German CPI numbers came in at just +1.7%, lower than the +1.8% expected and the +1.9% in May, after all. Should help the case for the ECB to reduce rates. I really cannot see the merits of another LTRO, though market expectations are high on this front. After all, the ECB has watered down collateral requirements which increases access by banks to ECB funds. Mr Draghi is fed up of having to act, given the failure of politicians to deliver, but what choice does he have.

Another interesting issue is China. There is mounting evidence that China is facing a major slowdown ie a “hard landing” – forget this “soft landing” rubbish. If they do not act pretty soon, they could face enormous political and social issues, their No 1 fear. I understand that the Chinese authorities were rocked by the Mr Bo business, especially as the army (the PLA) were involved. This has been smoothed over – presumably the PLA have been given a huge amount of goodies. The PLA are a major business in China, for your information. Capital flight is increasing rapidly. A stimulus programme (not called that though) is (very?) likely. I suppose they are waiting for the EU heads of State. The alternative, well……

Interesting times.

Kiron Sarkar

27th June 2012

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