It was probably the coordinated nature, rather than the substance, of yesterday’s announcement from the European Central Bank, the Bank of England, the Bank of Japan and the Swiss National Bank in coordination with the Federal Reserve that reassured investors and sparked a rally in risk assets. The announcement of three additional three-month dollar-liquidity-providing operations at fixed rate and with full allotment against all eligible collateral was particularly welcome following the sell-offs in French bank shares that preceded it and its coming on the day news broke of UBS’s latest risk-management fiasco.
Is it big news? Matt King, credit strategist at Citigroup, suggests it might be addressing the wrong problem. “Even though it is alarming that some European banks have not further reduced their loan-to-deposit ratios, and their surprising dependence on short-term funding looks like an accident waiting to happen, we do not expect any bank to fail due to lack of liquidity as they did after Lehman,” he says.
The ECB had already made it clear that it would provide unlimited liquidity to eurozone banks in euros. This latest news eases tensions over European banks’ reduced access to dollars and, perhaps even more importantly, offers a reminder to investors that policymakers around the world who stood together to avoid a meltdown in the aftermath of Lehman’s bankruptcy in 2008 presumably stand ready to act again.
ECB president Jean-Claude Trichet, speaking in Poland hours after the announcement, emphasized that central banks provide an anchor of stability. “The globally coordinated decision we published this afternoon on US dollar liquidity-providing operations is a clear illustration of our very close cooperation at the global level,” he said.
But he could not help himself from drawing a comparison unfavourable to others. “I would only remind all of us that the central banks – and the ECB in particular but with all others – have called permanently for sound fiscal management, sound economic policies and structural reforms, strict implementation and reinforcement of the European economic and fiscal governance – tirelessly, not only in stress times, but also in times of generalized benign neglect of both governments and markets. We call all authorities to implement swiftly all decisions and to be constantly ahead of the curve.”
Trichet’s speech neatly encapsulates why the latest relief rally is likely to be short lived unless it is quickly followed up with further action at the eurozone finance ministers’ meeting today and tomorrow.
The reason why European banks face a liquidity crisis is because of doubts about European sovereigns’ ability to consolidate their own finances without creating recession.
King and his credit analyst colleague at Citigroup, Hans Lorenzen, were making the point that the relief rallies following such announcements have grown shorter, in a presentation to credit market investors just after the news of central bank action came through.
Each time they are followed by policymakers dithering and failing to take firm action, once a big announcement halts an imminent market collapse. King says: “We’re worried that we’re quite close to the point where investor confidence is shattered.” He reports that while many investors Citigroup speaks to agree that credit assets are in theory cheap, they have no confidence to invest, particularly not in banks. Many, including hedge funds, even if they are not outright short the credit markets, are accumulating cash partly because they fear markets will fall further, partly to meet redemptions.
King says: “We are coming to the point where investors position for a crisis because it’s only a crisis that prompts policymakers to act.” Some investors the bank speaks to are up to 50% in cash right now.
He adds: “Policymakers are hemmed in by the unpopularity of both bailouts and austerity, so they only undertake them half-heartedly. Markets sense the implausibility of such measures and sell off. Investors’ confidence is further eroded and, with it, policymakers’ credibility.” Lorenzen adds: “The hurdles for policy intervention are getting higher. It’s got rational for policymakers to wait until things get worse so that when they take action it’s clear that it’s necessary even though it’s unpopular.”
Lorenzen includes the ECB in this. “While it looks that Spain and Italy have more of a liquidity crisis than a solvency crisis, there is no credible backstop at the moment,” he says. “There is the ECB but it is not committed. It takes every opportunity to say that it is only buying government bonds on a temporary basis.”
King and Lorenzen suggest that although credit markets should look a lot better in 12 months’ time than they do now, with spreads tighter than present wides that seem to price in a repeat of the aftermath of Lehman Brothers, the worry is what happens in the next few weeks. Things could get much worse before they get better.
| Price of an enlarged EFSF could be loss of AAA status |
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What might sustain the recent rally? Investors fear that a restructuring of the debts of Spain and Italy, if they are shut out of the markets, might overwhelm the tier 1 capital buffers of the banks. That fear would ease if there was a credible sovereign backstop, including a much bigger EFSF of at least €1 trillion – some market strategists suggest €2 trillion or €3 trillion – with confirmed ability to intervene in markets and, crucially, the ability to pre-fund starting now. Such a backstop would make it much easier for the IMF to play bad cop and for the eurozone to absorb without contagion a complete restructuring of Greek debt with 50% or higher haircuts. The price would be a loss of their triple-A status for France and Germany because the contingent liabilities of a much larger EFSF would push their total sovereign-debt-to-GDP ratios well over 100%.
It might well be a price worth paying. If the US isn’t triple A any more, what does it matter if Germany and France are not? It will be a tough sell though. Politicians won’t attempt to make it until Europe is teetering on the brink. It feels pretty close to the edge right now.
