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Europe Liquidity Crunch - Economics Weekly

Global Economics Weekly Brief

--- Europe Liquidity Crunch

Spain joined the critical list last week, and like Greece and Italy changed its political leader. That’s three new Eurozone leaders in the last three weeks.


Although elections were already planned in Spain, it’s clear that it was the Eurozone crisis that claimed the scalp. But a change of politician is not enough to solve the big issues. The world is still waiting for conclusive action to stop the contagion spreading any further. And it’s beginning to run out of patience. Meanwhile in the US, the ‘Super Committee’ charged with coming up with $1.2 trillion savings looks as if it might fail. Politics is the problem again as Republicans and Democrats dig their heels in. But every cloud has a silver lining. These wrangles put the UK system in a good light. Its policy making is more nimble because it can make its own monetary policy decisions and fiscal policy is not hamstrung by the opposition. And this is very good news for the cost of UK government debt. Main land Europe and the USA need to act swiftly to stop more major issues arising!

The Bank of England reduced its UK growth forecast. Slowing global demand, rising concerns about solvency in the Eurozone, and the risks these imply for international banking all led the Bank to revise its growth forecast. The Bank thinks the UK economy will stand still until the middle of next year and will grow by only 0.9%y/y in 2012 (Do we believe this growth!). But there was better news for households feeling the squeeze on real incomes. The Bank expects inflation to fall well below the 2 per cent target by the end of 2012 as the effects of VAT and a weak currency fade. While Sir Mervyn believes the deterioration in prospects is due to events outside of the Monetary Policy Committee’s influence, the expected fall in inflation ahead gives him room to expand the asset purchase programme. And he’s likely to take that opportunity sooner rather than later. As Sir Mervyn King predicated any solutions in the past to be right, no!

UK unemployment rate increased to 8.3% as public sector job losses outweigh private sector creation. The UK labour market is showing more signs of stress. In Q2, the 41,000 jobs created in the private sector were outweighed by a loss of 97,000 in the public sector after taking account of temporary census employment. This brought the overall level of unemployment up to 2.62 million. But worse news for the economy’s future productive capacity is that youth unemployment rose again. The number of 16-24 year olds unemployed rose to 730,000, or 20.6% in October, but including those in full time education, the level rose above 1 million, equivalent to a rate of at 21.9%. This rate will rise again in 2012 to over 23% together with more unemployment to rise to over 10%.

Consumer price inflation eased in the UK and US in October. UK CPI inflation slowed for the first time in four months in October. The rate fell to 5%y/y, down from 5.2%y/y in September. Food discounting at supermarkets was a major reason for the fall, but air fares and petrol costs also helped. This is welcome news, but core inflation (excluding food and energy prices) picked up to a six month high which suggests that there will still be some pain before things get easier. Milder weather should help UK households avoid the full force of the rise in utility prices for now, but this is little comfort when they look at the real value of their earnings and savings. Average earnings grew by 2.3%y/y in Q3 making real earnings growth -2.7%y/y. Meanwhile inflation since 2007 has eroded the real value of every £1 of savings to just 83p. The inflation story in the States was similar. US consumer price inflation also slowed for the first time in four months. At 3.5%y/y it is low compared to the UK, but underlying core inflation picked up there too.

UK and US shoppers hit the streets in plenty of time for Christmas. Despite the gloomy economic background, retailers on both sides of the Atlantic were pleasantly surprised by relatively strong demand in October. In the UK, sales increased by 0.7%m/m, which lifted the annual rate to 5.4%. This is all the more surprising given that unemployment is rising and consumer confidence has reportedly fallen to an all-time low. Pre-Christmas discounting may have loosened purse strings and retailers will be hoping they stay that way into the festive trading period. Experience was similar in the US, where sales increased for the 16th month in a row. The growth rate has edged down a bit, but at 7.2%y/y, it’s not to be sniffed at.

Economic growth in the Eurozone - for now. The Eurozone economy expanded by 0.2%q/q in Q3, as a rebound in Germany (0.5%q/q) and France (0.4%q/q) offset weakness in the periphery. But growth is still sluggish. Even with Germany and France driving output, the size of the whole Eurozone economy is only 1.4% larger than last year. And there are tougher times ahead. The deepening sovereign debt crisis is taking its toll and data for Q4 so far point to a Eurozone contraction. The pain won’t be confined to the weaker countries either. Close economic and financial ties with the periphery will affect the stronger core member states too, and this will have implications for the global, not just the European economy. Euro maintains even keel as we await inevitable EU response

Europe Liquidity Crunch

The liquidity crunch in Europe continues to worsen as we await the inevitable response. Meanwhile, the US budget super committee is a turkey as the US heads for four-day Thanksgiving holiday this weekend.

The noose is tightening around the Euro Zone’s neck, with the market showing further signs of the strain. The Euro basis swaps dropped to a new low for the cycle below -133 bps and equity markets tumbled and the USD surged, though some of that negative tone was set by Chinese official pronouncements on the prospects for the global economy.

In European bond markets, the developments were mixed, with further worsening of bond yield spreads to Germany in places (Notably, Spain’s 10-year yield moved higher than last Thursday’s record closing level and Greek yields moved to even more ludicrous levels of 267% on 1-year debt and 117.5% on 2-year debt as the market bets on a significantly worse than 50% eventual haircut. ) Elsewhere, yields were little changed vs. Friday’s closing levels.

Still, the Euro is holding up quite well, with EURGBP relatively sharply up on the day and EURUSD only easing lower, while the more risk-sensitive currencies bore the brunt of the risk selling pressure. This was despite a flap over European Commission demands that Greek political leaders sign a pledge to commit to the budget austerity program if they want to receive the aid (a Greek opposition leader has balked at signing). And the Moody’s bond rating agency was out today warning France on its rating, citing risks from elevated borrowing costs and worsening economic conditions.

Chart: AUDUSD
Chinese official rhetoric overnight, and commodity and risk appetite weakness were a perfect cocktail for Aussie downside, as AUDUSD is trading back below parity again for the first time in weeks. Interest rate differentials suggest even more room for downside, as the forward easing view for the RBA is reaching new extremes with more than 6 cuts expected from here in the coming months. The technical's are confused with the very wide swings of recent months, but the move back below parity is a significant blow and that level now acts as a symbolic resistance.

Is Europe set to declare a Chapter 11 in early 2012?

Europe may need to pull a Chapter 11 – a US-style bankruptcy, which would permit a market shutdown and Euro Zone reorganization before reopening for business.

The EU desperately needs a break from market pressures in order to allow the political apparatus to really gather its forces and finally move Europe and its debt crisis ahead of the curve. Here we are just a couple of weeks after the feeble attempt to apply an EFSF plaster on the problem and we’re already back to Square One: the EU debt crisis has reached the point at which none of the readily available tools or institutions are sufficient to match the magnitude of the crisis. This dictates the need for an out-of-the-box solution.

EU policy makers played the extend and pretend game for as long as they could - but now the writing is on the wall: popular outrage is on the rise and putting increasing pressure on the political process - as we are seeing increased demonstrations and grass-root activity taking over both the political agenda and the media. And markets are now balking as empty promises and now a real lack of funds are seeing bond yields beginning to spike out of control. The self-reinforcing cycle of downgrades and austerity and recession are taking us to the very brink of a full scale Crisis 2.0.

It’s important to point out that politicians will only do something drastic in a true state of emergency, so one catalyst we’ve yet to see to prompt action is a serious drop in the stock market.

Looking back at the implementations of non-conventional measures since the Global Financial Crisis got underway clearly shows that stock markets need to be down in excess of 20 pc from recent highs. The policy makers, wrongly, continue to buy the argument that stock markets reflect confidence- and faith in the future, ignoring the fact that the middle class has been the big loser since 2008 – The middle class is also the political establishment, so while “risk takers” in banks and the like continue to see no crisis ahead, the Main Street guy is feeling the crisis day in and day out. The consequences of this paradox will likely come to a head sometime in early 2012.

So what form might a Chapter 11 for the Euro Zone take? It is increasingly likely that some kind of total “bank holiday” is enforced to put a stop to market pressures – and then to reinforce and prelaunch a stricter EU Growth and Stability Pact as a price for cranking up the ECB printing presses to full speed.

Before accusing me of lunacy on my idea of a market holiday, it’s important to point out that banking holidays are not without precedent. In 1933, President Roosevelt declared a bank holiday that ran for an entire week in March of 1933, during which he passed the Emergency Banking Act and the Federal Reserve moved to supply currency to banks.

After 9/11 we also had a “forced” bank holiday. The banking panic of 1907 saw massive illiquidity and bank closings as can be seen in this excellent link. The main point for 1907 however remains: The biggest and most solvent banks survived, the small ones failed – 73 banks failed but it created a rebirth which catapulted the stock market higher.

Germany and Northern Europe understand that printing money at the ECB will not solve anything, as it would only throw more debt on an already back-breaking load. But if this bloc countries wants to buy time to implement stronger constitutional changes, the most path is a quid-pro-quo solution in which Germany gets a stronger Growth and Stability Pact implemented, not only into EU law, but also ratified as part of a new standard for restrictive fiscal policies with built-in debt breaks for all individual countries. Germany gets it “discipline leads to growth” for the long term, while the Keynesians get their “liquidity fix” from the ECB.

Clearly, if the ECB goes down the road of printing money, it’s more credible if such a solution came with new debt breaks. Still, how would this help to make Europe competitive? Yes, it could lead to lower interest rates across the stressed sovereigns of Europe, but considering that we have had lower rates for more than 10 years and falling productivity and growth in the same period, there is not any obvious correlation. Maybe rates (steering rates) are even too low?

There are several layers in credit markets now – banks get credit for free, AAA companies effectively do as well. Everyone else, meanwhile, has seen considerably higher interest rate margins and gross yield levels. This means that by “subsidizing” some sectors, others pay excessively in a relative sense. Is this the best way to allocate capital and credit? Hardly. If the unconventionally low rates were increased to their natural level (inflation + real rates), then the market would be more likely to allocate capital more efficiently and evenly relative to marginal returns. The zero interest rate policy has killed the distribution of risk and capital, unfortunately. The unintended negative consequences of the endless printing of money are inflicting tremendous damage.

The objective problem we need to deal with is to get more rules for debts, eliminate negative yields on government debt, get political backing for changes to the EU Treaty and secure democratic support for this.

The extend-and-pretend policies that have continued through 16 EU Summits have only led us to a Catch-22 in which everything that is done with good intentions (or not) is to the detriment of something else.


In short, the main issues are the following (in no particular order of prioritization):
Time is up – the market needs solutions, not plans for plans. The timeline for Political Europe is way too slow for market comfort.
Interbank funding is starting to freeze over. Every day sees risk factors pointing higher and a systemic liquidity crisis could develop at any time.
Financing gap. EFSF has 440 EUR 440 billion (though it has never been funded). Some estimate that Italy and Spain need EUR 400-500 billion per year to refinance and recapitalize its banks – per year! Talk about mismatch of supply and demand.
Lack of constitutional frame-work to establish or enact changes.
Democratic and constitutional rights are close to being violated, if not in the letter of the law, then certainly in the eyes of the voters.

As we head into 2012, I am increasingly convinced that we have an almost perfect economic and political storm brewing on the horizon.

Chart: EU growth forecasts - consensus estimates (YoY)



Now remember the “consensus” is always optimistic, that’s the rule of the game, so adjusting for the positive bias, we are looking at best at zero growth for Europe next year and most likely negative growth. This will mean a further strain on fiscal imbalances, higher unemployment, lower taxes, higher funding needs – you get the idea.

Now the interbank market is starting to freeze over and here is the real concern – the same happened in 2007/2008 and it was when currency basis swaps crossed the -100 basis point that the crisis escalated:


The basis swaps blowout reflects the distrust between interbank players and as such the car is running out of gas and could hurt the engine.

So the solution the market needs to at least partly solve the five problems I listed is to consolidate the need for “someone” to print and help out, while at the same anchoring the debt breaks and rules into the EU treaty, but also more importantly into the 17 nations that use the single currency.

This is going to prove such a difficult task that my rather radical call of a Chapter 11-like temporary shutdown is the only option I know of which could work. Somewhere inside the next three months we need to see a major change in politics, economics and investor will to look forward – the only way is to first feel and see the true Crisis 2.0, then to start thinking about ways to grow ourselves out of this crisis. Austerity will only work if done in environment of productivity and innovation, for that you need capital and transparency on outlook.

The alternative to my Chapter 11 is yet another cycle of what we have already seen - buying time and praying for better weather. But this route leads quickly to social disorder and a political backlash at election time. The moves in Europe by technocrats are increasingly been seen by voters as unconstitutional and in violation of democratic rights. The middle class across Europe was the big losers in the Financial Crisis of 2008/09. Now, with disposable income down, no outlook for jobs, and higher taxes on the way, no wonder there is renewed focus on the need for change.

We will get through this crisis – but it seems our democracies need to smell fear before making bold moves - that’s been the history of modern democracy, perhaps one of its best attributes. Regardless, in the end, the micro-economy will always take charge.

We have another global crisis that needs urgent attention by `skilled and experienced people` who can do the job right!


--- --- ---

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Note: About the Author Colin Thompson

Colin is a former successful Managing Director of Transactional/Print Manufacturing Plants, Print Management/Workflow Solutions companies and other organisations, former Group Chairman of the Academy for Chief Executives and Non-Executive Director, helping companies raise their `bottom-line` and `increase cash flow`. Plus, helping individuals to be successful in business and life in general. Author of several publications, research reports, guides, business and educational models on CD-ROM's/Software and over 400 articles published on business and educational subjects worldwide. International Speaker and Visiting University Professor.

The Europe Liquidity Crunch

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