Spanish banks...Mañana, Mañana...?

The Spanish government held a press conference this afternoon finally laying out its plans for dealing with its significantly troubled banking sector. As usual Spanish Prime Minister Mariano Rajoy dodged the limelight and left the unenviable task of presenting the proposals to his Deputy, Soraya Sáenz de Santamaría, and Finance Minister Luis de Guindos – despite this being par for the course with the new government we still can’t help but feel that it fails to inspire confidence.

That fact aside, the plan did include a few concrete details on how Spain plans to deal with the Spanish banking sector, below we outline the key points and give our take:

·         Two independent auditors will carry out an evaluation of all the real estate assets held by Spanish banks – the Deputy PM termed this “an exercise in transparency”.

Open Europe take: We have been calling for this for some time, so believe it is a positive step. However, we have seen that similar tests have been fudged in the eurozone and Spain before, so it is very much wait and see. Taking an adverse scenario and ensuring these assets are written down to their real values is key – if they start posting falls in the future it will reignite the uncertainty surrounding the banking sector. The Spanish government also failed to mention that, at least according to the Spanish press, de Guindos was going to be asked to hire independent auditors by his eurozone counterparts at the meeting of eurozone finance ministers next week.

·         By the end of 2012, provisions to cover against losses on real estate loans considered as ‘non problematic’ will have to increase from 7% to 30%.

Open Europe take: This seems far too low. Given comparisons to Ireland we expect real estate prices could fall by another 35% in Spain. Additionally, this move seems to be skipping a step – Spanish banks already have €136bn in ‘doubtful’ loans against only €54bn in provisions, surely provisions against these very risky assets should be increased first or at least in tandem.

·         In absolute terms, this means an increase of around €30bn.

Open Europe take: Again, far too little. We predict that Spanish banks would need to at least double their provisions, taking them up to around €100bn. Similar estimates abound, with RBS calling for an additional €100bn and Roubini Global Economics suggesting it could go as high as €250bn over the next few years. Meeting the Basel III capital requirements will put further strain on the sector.

·         Banks will be allowed to get money from the FROB, but will have to pay 10% interest on it – Spanish Economy Minister Luis de Guindos stressed that this money cannot therefore be seen as state aid. Suggested maximum use of public funds would be €15bn. Heavy use of ‘contingent convertible capital’.

Open Europe take: This seems to be poorly thought out and based on an ideological reaction. Clearly the government is keen to avoid being seen to bail out banks, and rightly so. However, the banks tapping these funds will be those locked out of the interbank funding market (due to high rates), punishing them with 10% interest will make this recourse worthless. Any use of public funds should come with strong conditions but better to focus on letting some banks fail and be wound down in an orderly fashion, while forcing those that take funds to produce ‘living wills’ and give the state equity warrants. Contingent convertible capital can be useful but does not fundamentally solve the problems facing the banks, again it simply delays dealing with the problems and kicks in as a last resort safety mechanism – will do little if provisions are shown to be woefully small or valuations far too high.

·         Spanish banks will be obliged to transfer real estate assets into ad hoc societies tasked to sell them on the markets – i.e. the ‘bad bank’ that dare not speak its name.

Open Europe take: Potentially a large burden for the state, but given the breadth and depth of the problems across the sector some form of ‘bad bank’ scheme looked hard to avoid. The key here will be transferring the assets at realistic values so that they are sellable or can be written off. The Irish experience with NAMA makes this point clear – a bad bank stuck with uncertain assets can be a huge burden to the state. Furthermore, it could also distort the recovery of the sector as a whole, if the overvalued assets pile up on state books it will be hard for the remaining market to adjust – something which is necessary if the Spanish economy is to rebalance and recover.

The market response to the proposals has been lukewarm at best with Spanish borrowing costs rising slightly and the shares of many Spanish banks falling sharply.

There are some positive steps in the proposals and we will reserve full judgement until the complete package is announced and the stress tests have been detailed, however, it again seems to be a step short of what is needed. The key to tackling these banking sector problems is doing so decisively and in one swoop, rather than pushing the problems to tomorrow. Incremental adjustments increase uncertainty and expose the state to a longer and more volatile burden than needed - given the size of the Spanish economy, that is something which the eurozone cannot afford now or in the future. 

The Spanish sovereign-banking loop

A heavy going blog post for a Friday afternoon, but you can digest it over the weekend (lucky you!). One of the key themes we highlighted in our recent briefing, comment pieces and general coverage on Spain is the importance of the sovereign banking loop.

The idea here is that the fate of the Spanish banks and the Spanish state are becoming increasingly intertwined. The two are always connected: if a state goes down normally its banks will too, while if banks fail the state often has to bail them out to support itself (or at least that is the prevailing logic).

As the eurozone crisis has progressed numerous states (PIIGS) have had significant trouble funding themselves (selling debt). In many cases the only people willing to buy a sovereign’s debt has been their domestic banks. In turn, a situation arises where banks pile more and more risky debt while the state becomes entirely reliant on them for financing. Far from ideal.

The unlimited ECB lending and the LTRO has only exacerbated this cycle and there is a strong correlation between increased reliance on ECB funding and the sovereign-bank loop – Spanish bank borrowing from the ECB jumped by €75bn in March, an increase of 50%.

An editorial in the FT today argues that the Spanish government has done well to avoid recapitalising its banks at cost to taxpayers, especially since many of the banks could fail without bringing down the state. This is undoubtedly a positive thing - taxpayers should be kept out of the equation as much as possible as taxpayer-backed bailouts invariably create the wrong incentives (i.e. moral hazard).

But for intellectual honesty, it's also vital to account for all sides of the sovereign-banking loop.

As we noted in our recent briefing the primary aim should be to force banks to recapitalise themselves and ensure they have sufficient provisions against bad loans. However, if they get into significant trouble the chance of a self-fulfilling bond run on Spain increases significantly as the domestic banks stop buying bonds. This could push the whole country into a bailout, which the eurozone could barely (if at all) afford.

This situation is a clear side effect of the failed policies taken on by the eurozone and the ECB, which we have long argued against – failing to tackle the underlying back solvency problems, loading them up with cheap liquidity and encouraging them to fund struggling states was always going to lead us here. Unfortunately, given the state of affairs now, suggesting that Spanish banks are too small to bring down the state misses how dependent the state is on cash from domestic banks.

A Spanish banking crisis and the ensuing bond run on Spain are very real threats to the eurozone. The Spanish government needs to push banks to increase provisions against losses and a thorough stress testing would go some way to highlighting just how much they need. We are loathe to suggest any cost be transferred to taxpayers, but realistically (given the eurozone's bail out policy) this option may what the Spanish government and eurozone leaders have to go for in the end, either through the FROB (Spanish bailout fund) or the ESM (eurozone bailout fund). If so, it's of course extremely important that any funds should come with strong conditionality including giving the government preferential shares and equity warrants as well as forcing banks to produce ‘living wills’.

But whatever happens, eurozone leaders must stop seeing a bail out as an end in itself. If it comes to that, unlike the ongoing ECB and bailout operations, any injection of funds should be part of a full assessment of the viability of the institution with fair consideration given to the prospect of winding those down that don't have a sound financial footing for the long term. Banks must simply be allowed to fail. Ultimately, purging the bad practices and poor management which helped fuel the boom and bust in Spain will be vital for the long term health of the banking sector and the economy.

The link between the health of the Spanish banks and the health of the Spanish state remains very strong - unfortunately neither is looking in a good position right now.

Light at the end of the tunnel? Not yet...

Update 10 February, 9:45 am

Greece's letter of intent (29 pages including the annexes) with all the envisaged austerity measures is available here



After countless missed deadlines, numerous strikes and some very exasperated European officials it seems there is an agreement in Greece. Finally.

Despite the failure to achieve one overnight, an agreement had been coming given that only one point of disagreement remained – on pension reform. The Greek political parties refused to cut primary or supplementary pensions further, leaving a €300m gap in the Greek budget – pretty small given the huge sums at play in the Greek deal.

The statement just released by the Greek PM is minimalist to say the least - only two sentences. It confirms that a deal has been reached and suggests the total bailout size will be €130bn.

So what does this deal mean?

Well, it is positive in that it moves the whole Greek discussed forward one large step, but it isn’t the end of it – not by a long way. Essentially, the Greek unity government has now agreed and committed to a new programme of austerity, just one part of the wider Greek package and in itself not necessarily productive. As we have flagged up elsewhere austerity alone cannot and will not solve the Greek problem and could be on the verge of becoming counterproductive given the economic (low growth) and political (civil unrest) implications.

It also allows a deal to be presented at this afternoon’s meeting of eurozone finance ministers, allowing progress on some of the other remaining questions, which include:

- What structure will the bailout take (in terms of allocation of funds and distribution of payments)?
- What will the total level of debt reduction from the restructuring be?
- When will the restructuring begin and will it be in time to pay off the €14.4bn in debt maturing on 20 March?
- Will the European and Greek parliaments approve all aspects of the deal?
- What role is the ECB playing? Will it submit its holdings of Greek debt for restructuring?

This afternoon’s press conference with ECB President Mario Draghi was fairly cryptic on this last point, with Draghi trying to dodge questions about the ECB and Greece for the most part – although he did drop a couple of hints.

Our take is that the ECB may, very reluctantly, take some part in the Greek restructuring. It will not take any losses and is hesitant to transfer its bonds to the EFSF, the eurozone bailout fund, even at cost price. One possible outcome could be that the ECB will distribute the potential €15bn in profits from its holdings of Greek debt to the eurozone countries (since they are the ECB’s backers and already share in its profits) to be put to use in funding Greece. How this can be done upfront, especially without using the EFSF, remains to be seen.

Additionally, the fact that the Greek PM’s statement specified the bailout amount as €130bn suggests that there will still be a budget gap in Greece which needs to be filled, even with the agreement on the additional austerity. An ECB contribution seems to be the only remaining viable way to close this gap then.

So, we are eventually one step closer to another bailout of Greece. The end to the uncertainty is positive, but in the long term it seems to be just another step along the wrong path.

The Greek end-game?

Greece is on a "knife edge". That was how Greek Finance Minister Evangelos Venizelos put it on Saturday ahead of emergency talks between Greek political parties and the EU/IMF/ECB troika (with eurozone countries and private sector bondholders thrown in there somewhere as well).

We're sure you're thinking - surely, we've heard this all before? That may be the case, but unfortunately this time may be different. For once, Greece has a hard and fast deadline to meet to avoid a disorderly default.

But lets back up a second, whats the current disagreement between the Greek government and its creditors all about? Well, despite seemingly getting talks with the private sector bondholders pretty much finalised, new gaps between the Commission/ECB/IMF troika and Greece have opened up over the second bailout (as we predicted in our previous posts). The main areas of contention (as expected) seem to be the desire for eurozone countries to see greater wage and spending cuts. However, the three party coalition which underpins the 'technocratic' government of Lucas Papademos is refusing to back greater austerity - they simply believe their parties and the public won't support it. They may well be right but they may also have one eye on upcoming elections (as has been suggested). All of this puts the eurozone at yet another impasse. There is no way eurozone states will agree to disburse another €130bn - €145bn without a greater commitment to austerity in both the Greek public and private sectors. But without support from all three parties any commitment would be an empty one.

Usually, this would spell another round of talks, negotiations and some form of muddling through. However, this time they have essentially set a deadline of the start of this week to finalise the entire Greek package. The reason for this is the €14.4bn in Greek debt which needs to be paid off on 20 March. For the next bailout to be released, the 'voluntary' restructuring needs to have taken place and the new austerity measures need to be making their way through parliament. Without the money from the second bailout Greece will not be able to pay off this maturing debt. Most experts and those involved expect that six weeks is the minimum amount of time it will take to put the restructuring in place - meaning that it needs to get underway this week, hence the deadline.

There is also the 'side' issue of how much money will actually be paid out in the second bailout and whether the official sector (eurozone loans/ECB) will take losses in the restructuring. These are in themselves massive issues which will affect the future of the eurozone - particularly the role of the ECB (as we have previously discussed here). But in the eyes of the eurozone these discussions cannot even take place until there is a consensus from the Greek political elite to commit to greater austerity. Unfortunately, then, there are still some very big issues to be ironed out, even after the current disagreement is settled.

The term "knife edge" does seem fitting here...

Updates 06/02/2012: We will continue to update this blog with developments from Greece throughout the day.

09.30am - Reports this morning suggest Greece has been set a deadline of noon to find an agreement amongst the political parties in favour of the necessary austerity. However, this has been denied by Greek officials, who suggest the deadline is simply for an agreement to be struck ahead of the next eurogroup meeting (which was due to take place this afternoon but has now been moved to an undefined date).

12.20pm - RANsquawk is reporting that the Greek political parties have reached an agreement on a 20% wage cut and a reduction in supplementary pension, pushing them closer to a deal with the troika. No formal announcement yet but one is expected later today. Meanwhile, Merkel and Sarkozy have been holding a joint press conference in which (other than praising each other) they continued to reiterate their firm stance on Greece, although also stating that they expect an agreement very soon. If there is a consensus found in Greece today we can expect an emergency Euro-group meeting tomorrow or Wednesday.

2.00pm - Despite rumours of an agreement being reached, it looks as if the negotiations are far from over. Greek Prime Minister Lucas Papademos is set to hold talks with the troika later this evening to update them on his progress. Papademos will then hold another meeting with Greek political leaders tomorrow, presumably to communicate any messages which the troika wish to send. We assume the message will be for greater austerity. So don't expect a Euro-group meeting until at least Wednesday.

2.20pm - France and Germany earlier requested that Greece create a special account targeted at financing Greek debt, although specifically paying off interest rather than the total amount for now. The plan remains unclear and undeveloped but seems very similar to the recent German demands that Greek bailout funds go towards paying off debt first and foremost. Could the issue of an EU budget commissioner be revived during these negotiations then? Unlikely, but still risky ground for the French and Germans to tread given the heightened tensions since that leaked document.

5.20pm - After a slightly quieter afternoon than anticipated, AP has announced that there is a consensus between the Greek parties to accept the demand to cut 15,000 public sector jobs. A deal looks to be edging closer but is far from sealed yet. There is also set to be a general strike for the whole day tomorrow, meaning there is a good chance of massive protests and possibly even large riots in Athens.

6.15pm - Things have picked up again in the last hour, particularly with Greek PM Lucas Papademos reportedly asking the Greek Finance Ministry to do a thorough assessment of what a Greek exit from the eurozone would mean. Papademos is currently in a meeting with the troika (which began at 6pm), during which we're sure these reports will be broached, mostly likely with some disdain on the part of the troika. In the meantime, Merkel and Van Rompuy have been reiterating their positions by continuing to insist that the situation is not as bad as it seems and that Greece can avoid a default.

The summit to end all summits

At least that was how it was being seen beforehand. Unfortunately, in the aftermath it seems to have fallen short of expectations (although admittedly the dust is yet to fully settle). Nevertheless, it was an interesting summit, especially for the UK. Below we outline the key outcomes of the summit giving our assessment of the economic, political and legal impact which the decisions may have (read our full press release here).

1) Treaty change

Summary: Failed to agree to a treaty change involving all 27 member states. Eurozone members will push ahead with a new treaty for the 17, plus a possible 9 other EU states, pending consultation with national parliaments. Aim to incorporate the measures into the EU Treaties as soon as possible.

Open Europe’s take: The legal basis for the new intergovernmental treaty is still not clear. It will be very legally complex for the new group to use EU institutions to enforce the new treaty without the consent of the UK. As such, the negotiations are far from over, particularly since eurozone leaders are still keen to incorporate the measures into the Treaties and push further in the future in terms of integration.

Was Cameron right to use his veto? How might it impact on UK – EU relations in the future?

- Cameron had little choice but to exercise his veto given the importance of financial services to the UK economy and his need to balance domestic party concerns. His demands were not excessive, particularly given that other EU members have issued similar national demands during this crisis, e.g. Germany over Eurobonds and the ECB’s role, France over using the European Court of Justice (ECJ) to enforce fiscal sanctions and now Finland over the use of QMV in the ESM.

- There was never any discussion of the UK taking part in the new ‘fiscal compact’ but merely whether it would approve the treaty change or not. As such, the UK’s position has not changed within the EU itself. The political dynamics may have changed but whether this will turn out to be better or worse for the UK remains to be seen.

- There is still a huge legal mess to sort out. Whether the new treaty will be enforced by EU institutions or not remains unclear, as is the UK’s role in future proceedings, but it looks likely to be a massive legal stretch to use the existing EU institutions for this new treaty.

- There are valid concerns that Cameron received no clear safeguards while spending a lot of political capital. In order for this to be a sound investment, it needs to be followed up with a concerted push for a more flexible, adaptable and competitive EU in which the UK can feel at home. In the wake of the eurozone crisis, Europe will need a new grand political settlement, which can take years and in which the UK, like all other EU countries, will push their interests.

2) Fiscal compact

Summary: Commitment to balanced budgets, with an annual structural deficit limit of 0.5% enshrined in law and a clear, automatic correction mechanism for when this is broken. Legal enforcement judged by the European Court of Justice (ECJ). The Excessive Deficit Procedure will be strengthened; any country which breaks the 3% threshold will be subject to Commission sanctions unless a qualified majority of eurozone states oppose them. Examine new Commission rules on economic governance and increase surveillance.

Open Europe’s take: Only difference from the stability and growth pact is that qualified majority voting is reversed. Not a particularly credible or strong fiscal compact. There are significant concerns that if countries such as Germany and France struggle to meet the requirements, they will be watered down. Missing out on strong ECJ enforcement and European level automatic sanctions reduces the impact of these measures, unlikely to be enough to convince markets or the ECB that fiscal discipline will be maintained in the long term. Not clear what a national automatic mechanism for correcting budget deficits would be. This seems to be the start of a process, installing fiscal straight jackets on struggling eurozone countries if they wish to stay in the eurozone long term – not clear where their growth and competitiveness will come from.

3) European Stability Mechanism (ESM)

Summary: Move up entry into force to July 2012 or as soon as members representing 90% of capital commitments have ratified it. EFSF will run until mid-2013 as expected, although deciding how the two will run at the same time (given current restrictions in the ESM treaty) will be delayed until March 2012. ESM wording on private sector involvement in future bailouts will be watered down, highlighting that Greece is “unique and exceptional”. An emergency procedure will be added to ESM voting rules, which states that 85% QMV threshold can be used to make decisions if the Commission and the ECB believe the financial and economic sustainability of the euro is threatened.

Open Europe’s take: Moving up the ESM is broadly positive from a market perspective, although the key issues about its implementation have been delayed. One concern is that the sped up timeline for paying in capital resulting from this move will increase pressure on the funding needs for eurozone states. Removing private sector involvement may calm markets in the short term but could be a mistake in the long term. Takes us back to where we were with EFSF bailouts, simply recycling debt around the eurozone with no clear goal for tackling solvency. Although the QMV rule has to be approved by the Finnish parliament, the “emergency procedure” seems misleading – in what instance would giving a bailout not be seen as an emergency?

4) IMF

Summary: Decide within 10 days whether to provide €200bn in bilateral loans to the IMF general resources fund, via national central banks.

Open Europe’s take: The IMF can apply more conditionality on lending, so it is preferable to the central banks doing it themselves. Still only offers a short term liquidity boost to countries, unless IMF is able to enforce broader economic restructuring which the eurozone looks set dead against. Raises questions over the independence of central banks, since they are giving up money to a general fund to be controlled by an institution with completely separate aims. May be opposed by the ECB and/or Germany depending on format. Even with this additional funding the IMF capacity for bailing out Italy and/or Spain still falls well short.

Inverting Italy

Things have gotten very bad, very quickly for Italy this morning. Italy’s 10 year borrowing costs opened at 6.8%, already very high but many expected some quick ECB bond buying to help bring it down substantially. However, with the ECB nowhere in sight the yield has shot up to 7.45% at pixel time. It’s not clear exactly why this has happened, with markets looking slightly confused as to how to respond to the events in Italy last night.

Berlusconi said that he will resign once the economic reforms, which he promised to EU leaders, were put in place. Talk of his resignation has previously lifted markets, however, given the tentative nature and uncertainty surrounding yesterday’s announcement markets are not certain on how to take it (equities have responded well, while bond markets are all over the place).

Across the board (for all maturities) the borrowing costs for Italian debt have been increasing, but importantly the rates for shorter term debt have now overtaken those on longer term debt (aka. the yield curve has become inverted). This is worrying as it signifies that investors are seeing an increasing default risk in the short term resulting from huge levels of uncertainty. This phenomenon was seen in Greece, Ireland and Portugal before they requested bailouts and is often a sign of the situation approaching a self-fulfilling spiral, where borrowing costs skyrocket into unsustainable territory.

In purely technical terms the costs are not quite unsustainable yet. Italy has a large amount of debt to rollover in the coming months and years, but it could stomach these rates for a few months if they were to come down eventually. Ominously however, Greece and Ireland lasted 13 and 15 days respectively, with 10yr rates above 7% before asking for a bailout and while Portugal managed to drag it out to 49 days - once the 7% threshold is breached it is rare for a country to drop below it again without outside intervention.

The best thing to do now would be for Berlusconi to go as soon as possible, once a plan for a unity government to take over from him is in place. These negotiations need to happen quickly, with a clear timeline and plan of action for the new government outlined publicly. The market is yearning for some certainty in this situation, Italy and eurozone leaders must step in to offer some.

Berlusconi's last stand?

Update 15:50 - The vote on the 2010 budget review in the lower house of the Italian parliament has just taken place. As expected, the review was passed because opposition MPs abstained. However, the 'yes' votes were only 308, meaning that Berlusconi has effectively lost the majority in the chamber. Previous reports suggested that 311-312 MPs would vote in favour of the review. In fact, Italian Infrastructure Minister Altero Matteoli admitted, "We were expecting different numbers." After the vote, Berlusconi reportedly talked briefly to his key ally Umberto Bossi - the leader of junior coalition partner Lega Nord. Italian Economy Minister Giulio Tremonti (who skipped part of today's meeting of EU finance ministers to vote on the budget review) and Interior Minister Roberto Maroni were also present.

For the latest updates on Italy, you can follow us on Twitter @OpenEurope

And here is what we published this morning:

Open Europe has today published a note on the dramatically evolving situation in Italy, with new estimates on how much the rising bond yields could cost the Italian government and an assessment of the current political situation.

The last week has seen Italian borrowing costs consistently increase (and thus prices fall) despite purchases by the European Central Bank. This is mostly down to the political deadlock in Italy and the increasingly untenable position of Prime Minister Silvio Berlusconi. In this briefing note, Open Europe looks at the economic and political situation in Italy and how it could unfold over the coming days and weeks.

Key points:
• Berlusconi’s majority in the lower house of the Italian parliament remains uncertain;
• If Berlusconi falls, the best option for Italy and the eurozone would be a national unity government with a strong backing in the Italian parliament;
• At current borrowing costs Italy could face an extra €28bn in interest payments over the next three years, potentially wiping out almost half of the projected €60bn budget savings by 2014;
• Italy needs widespread institutional as well as economic reforms if it is to return to economic growth.

“Another decade of stagnation a major risk…Another decade of disappointing growth would make public debt difficult to sustain…Declining public bond prices would worsen banks’ and insurance companies’ balance sheets, with a possible vicious cycle.”
- IMF Staff Report on Italy, July 2011

This morning, Italian ten-year borrowing costs reached a record 6.74%, very close to the 7% threshold which financial markets see as broadly unsustainable (and which therefore often results in a self-fulfilling solvency crisis and possibly a bailout). Similar increases have been seen across the board for Italian debt of all maturities. Worryingly, short-term debt is becoming increasingly expensive (the yield curve is flattening) a sign that investors see increased risk in short term lending (something seen in the other countries which accepted bailouts).

However, rumours of Berlusconi’s resignation triggered a rebound-effect on the stock markets yesterday. There should be no doubt that, although Italy’s difficulties will not be resolved if Berlusconi goes, he is definitely a big part of the problem. So will Berlusconi resign, and what will it mean for Italy and the eurozone?

To read the full briefing click here

So, who’s running Greece?

We’ll be updating this blog throughout the day with details on the state of the Greek government and the Greek Prime Minister given recent rumours about a change in both. We’ll also cover the dwindling prospects of the Greek referendum ever being held. All times are in GMT.

17.00: - Following a thoroughly confusing and rambling speech by Papandreou it seems that the referendum has been put on hold, for now (this was eventually confirmed by the Finance Minister Evangelos Venizelos). According to Papandreou the referendum was being considered because there was no clear consensus (in parliament or in the country) on whether to support the bailout package. Now that the opposition party the New Democracy has said it will support the deal (see below) he will put the referendum on the back burner and push ahead with finalising and implementing the deal.

- Not clear what format the government will take here, but we imagine New Democracy will not agree to the programme without some concessions. Another unity or cross party government could be on the cards then, with it be unlikely that Papandreou will be at the head of it. Ultimately, this will be decided by tomorrow's confidence vote.

- There were also some strange comments from Papandreou in general such as, "there was never any question on Greek membership of the euro", referendum has had a "beneficial shock" for Greece and that Greece is "bearing a cross and they are throwing stones at us" (not clear who they are exactly).

- Dutch Finance Minister for one (and us for two) was not convinced by the change of heart saying,“I have the experience with the Greeks that today is today and tomorrow is tomorrow.” So, we doubt this will be the end of the referendum talk or the speculation.

Open Europe take: Not Papandreou's finest moment, a terrible speech, lacked clarity and didn't tackle the key issues. It seems that the decision to call a referendum may have been a ploy to get the opposition to support the latest bailout package, although to some extent it did come across as the PM's last stand. In the end, avoiding the uncertainty of a referendum may be beneficial for Europe, despite the mess that has been created with its announcement. This has all be handled poorly by the Greek government and eurozone governments. Ultimately, Greece needs the next tranche of EU/IMF aid to survive through to end of December, as such avoiding a disorderly default may be the best outcome here. That doesn't change the fact that the bailout package is still flawed and does not solve the crisis.

14.45: Following a flurry of contradictory messages from Athens this morning and afternoon, it appears a (slightly) clearer picture is emerging. Papandreou has acknowledged that he won't be able force through the referendum, meaning it has been scrapped. The Guardian's live blog reports that some members of Papandreou's party are currently locked in negotiations with the New Democracy opposition over the creation of a Government of National Unity, also being dubbed a Salvation Government (this strikes us as somewhat hubristic). However, the vote of confidence scheduled for tomorrow is still due to take place (for now).

This is not only a big U-turn by Papandreou, but also by New Democracy's leader Antonis Samaras who has reportedly agreed to the details of the EU's bailout package; previously the party had argued in favour of securing a more favourable deal, with less focus on austerity.

13.30: - As it stands, BBC reports that Greek PM George Papandreou is currently speaking with the Greek President Karolos Papoulias and will offer his resignation in the immediate future (however there are still conflicting reports coming from ‘unnamed Greek sources’ suggesting this will not happen).

- Reports suggest that Papandreou’s government is too fractured to survive his resignation and as such the President will need to form a new government. This will likely be a cross-party transitional government, headed by former Greek Central Bank President Lucas Papademos.

- This government has the support of the leader of the opposition party New Democracy, Antonis Samaras, who earlier called for a unity government to be put in place. Samaras also stated that he would support this government approving the latest bailout package, despite previously suggesting he may look to renegotiate.

- After the latest package is approved, general elections will be held (quickest turn around would be 23 days after they are announced) leading to a possible New Democracy government. Questions still remain over the party’s long term commitment to enforcing more EU/IMF austerity. All this means, as of now, it looks very unlikely that there will be a referendum.

Open Europe take: Despite being all over the place, if this happens it could be a reasonably positive outcome. Still huge problems with current bailout plan and better options (proper involuntary debt restructuring) but of course still preferable to a disorderly Greek default and disorderly exit from the eurozone. That said, as we argued on the Today Programme this morning, EU leaders should promptly be planning for all eventualities and not living in denial any longer.

No way out? Short term options for the eurozone

The window of opportunity for stabilising, or even saving, the eurozone is closing quickly. As EU leaders gear up for a series of key meetings this week, Open Europe has published a new briefing looking at the short-term options available to the eurozone for tackling the most immediate crisis.

Open Europe argues that Greece should default on 60% of its debt through a managed restructuring, and that the planned second Greek bailout should be scrapped altogether, replaced by a limited transition fund designed to control the default. This would radically reduce the burden on taxpayers. Portugal should simultaneously take a 25% write-down on its debt.

Alarmingly, however, Open Europe estimates that 65 banks across the EU would fail serious stress tests, falling below an 8% tier one capital ratio, meaning they require a substantial recapitalisation. To withstand a Greek and Portuguese default, combined with marking Irish, Italian and Spanish debt to market prices, the EU banking system would need to be recapitalised by between €260bn and €372bn. The briefing sets out a three-pronged strategy for how this can be achieved, including a role for the eurozone bailout fund, the EFSF, but with strong conditionality attached.

However, using the EFSF to insure a percentage of Spanish and Italian debt against default – a proposal which is currently being discussed – would merely create a new set of unfunded liabilities, which markets are likely to question sooner or later.

The briefing also concludes that EU leaders should rule out forcing the ECB to act as the eurozone’s lender of last resort by buying hundreds of billions of government bonds – an option favoured by many. The ECB is already taking on risky assets at a worrying rate, and now has an exposure of around €590bn to PIIGS, up from €444bn only this summer, in turn undermining its independence and credibility.

See here for full briefing.

Regling goes loopy

This Greco-Finnish collateral deal is turning out to be quite the thorn in the side of eurozone leaders. As with all such problems, it has begun to attract all manners of solutions. One of the more interesting and outlandish ones was covered by Handelsblatt yesterday, reportedly put forward by none other than Klaus Regling, Head of the European Financial Stability Facility.

According to the German daily (although without citing sources) Regling has suggested to eurozone Finance ministers that Greece partly nationalise its banking sector and then use these bank shares as collateral with Finland in exchange for the Finnish share of the bailout loans. Sounds simple enough, although it has one slight snag – the collateral offered would be worthless in the event that the Greek state failed to repay the bailout loans.

It’s been noted that there is a significant sovereign-bank loop going on in Greece. Greek banks have almost solely survived on using Greek bonds and state backed bank debt to obtain loans from the ECB. If the state fails to repay its bailout loans, which would mean Greece had defaulted, these huge amounts of state debt and guarantees which help support the banking sector would unwind and the banking sector would collapse. Not to mention the fact that it would already have been partly nationalised and so would be directly state backed to some extent. (There's also the small issue of the banks being recapitalised with bailout funds and possibly by the EFSF in the future - presenting even more of a conflict).

The long and short of it is, Greek state defaults, Greek banks go under, therefore their shares are worthless as collateral.

Seems obvious enough but the reports suggest this plan will be the starting point for the discussions at 16 September meeting of eurozone finance ministers, at which a deal is expected to be finalised. If the plan does follow this proposal in some form it will be the mother of all sovereign-bank loops, with eurozone governments propping up Greece with a bailout, which is propping up Greek banks, the shares of which are being used as collateral to prop up the bailout.

In any case, we’re sure Finland is smart enough to figure all this out (and more) for themselves making this proposal, as with so many others, look dead on arrival.

Merkel finds some peace and quiet away from those noisy markets

In the wake of massive financial market turmoil, most eurozone leaders have taken to running around like headless chickens. German Chancellor Angela Merkel, on the other hand, has decided to put her feet up and relax.

Away on holiday in the chilled-out South Tyrol, Merkel has confirmed that she’ll be away for next week too. Question is, will the eurozone still be in working order by the time she’s back?

In an attitude reminiscent of the legend of King Canute, Merkel's office today declared (on her behalf we should add):

“Markets caused the drama now they have to make sure to get things straight again”

It's like taking a bull into a china shop, watching it destroy half the store and then leaving to let it clean up its mess....

Greece leaving the EMU: From taboo to fashionable?

First it was the idea of eurozone bail-outs, then it was restructuring, now another eurozone taboo has been completely smashed: Greece leaving the Single Currency. In fact, over the past few days, it appears as if arguing in favour of Greece leaving the eurozone has become almost fashionable.

The speculation really kicked off when Der Spiegel revealed that a "crisis meeting" had been called in Luxembourg, following rumours that the Greek government was considering leaving the eurozone (although the main topic on the agenda for that meeting was probably restructuring and another bail-out package).

Despite the usual round of denials ("there's no meeting", "Greece is just fine", "Elvis is alive" etc) people are now falling over themselves to be candid. Greece's EU Commissioner, Maria Damanaki, for example. Becoming the first EU official to speak the unspeakable, she said,

The scenario of Greece's exit from the euro is now on the table, as are ways to
do this. Either we agree with our creditors on a programme of tough sacrifices
and results...or we return to the drachma. Everything else is of secondary
importance.

Clearly an attempt to put pressure on her countrymen to get on with business, but a bold statement nonetheless. And the last few days have seen a slew of politicians and commentators following suit. Writing in De Telegraaf, former Dutch Finance Minister Willem Vermeend argued that "Greece should leave the euro", given that it will never be able to pay back its debt.

In an interview with Handelsblatt, German FDP MP Frank Schaeffler - the standard bearer of the German no-bail out movement - said,

As long as Greece hasn't privatised a single cent worth of assets, increasing
the aid would be absolutely the wrong signal. At the same time governments must
help with an orderly eurozone exit.

(Schaeffler has been arguing this for a while, it should be said, in April 2010 - before the Greek bail-out was even agreed - he said that Greece should be prepared to "voluntarily leave the eurozone").

An increasing number of academics and commentators are now also suggesting that Greece should take a hike - be it temporarily or permanently. Harvard Economics Professor Martin Feldstein, for example, who this week argued,

A temporary leave of absence from the eurozone would allow Greece to
achieve a price-level decline relative to other eurozone countries, and would
make it easier to adjust the relative price level if Greek wages cannot be
limited.

In the WSJ, Editor of German weekly Die Zeit Josef Joffe wrote that,

Greece faces default no matter what it does, but only abandoning the euro
would give it a chance at growth.

And in today's FT, columnist John Plender chimes in,

If a package is agreed in June, which seems probable, the challenge will be to bring Greece to a primary budget surplus where revenue exceeds costs before interest payments. At that point, it would be sensible for Greece to bow out of the monetary union and take advantage of currency devaluation. For that to work, though, European banks would need in the interim to have bolstered their capital. And the execution risks are phenomenal. This is policymaking on a wing and a prayer.

And you know where we stand - the eurozone, in its current shape and form, is simply unsustainable (see here, here, here and here for example).

Why is Portugal in trouble?

Solving the problem should undoubtedly be the priority now, but looking at how Portugal got into this mess might help to formulate a solution.

Clearly there were many factors which helped to precipitate the current crisis, including numerous domestic political and policy mistakes. However, being a member of the single currency definitely seems to have played a part.

According to an interesting paper published by European Commission officials, joining the euro had the following consequences:

"The Portuguese economy went from a boom led by in the second half of the nineties to a marked slowdown in this decade (Chart 1). A major impulse for the expansion was the considerable fall in interest rates when the prospect of accession to EMU became increasingly self-validating. Nominal short-term interest rates fully converged to those at the common low level set by the ECB (Chart 2)."

The paper suggests that the "substantial fall in interest rates, [was] the main trigger for the boom", which later resulted in a bust. The interesting difference with Portugal, compared to Spain, Ireland and Greece, is that it experienced the infamous boom - bust dynamics before it entered the eurozone, but still because of the "prospect of accession to EMU", as the officials put it.

The eurozone's "sleeping pill" dynamics (as Herman Van Rompuy puts it) have prevented investors from forcing the country into unpopular, but necessary, reforms to boost competitiveness, resulting in Portugal becoming 21% less competitive relative to Germany over the past decade (this looks to be true of the past and current crisis).

So when Portugal experienced its bust, long before Spain and Ireland experienced theirs, there wasn't a currency which could come under strain and thereby discipline the politicians. This was surely one of the reasons for the consistently sluggish growth in Portugal following its bust.

There is, obviously, more to it though. Thanks to the ECB's artificially low interest rates, which were designed for a slow growing Germany, the country started accumulating very high levels of private debt, up to more than 200 percent of GDP (just like in Spain and Ireland, however, they managed to grow at the same time ).

On top of all of this, the Portuguese government hasn't exactly been a shining example of sound budgetary management. It has run large budget deficits for many years and has accumulated a significant level of debt for an economy the size of Portugal's (both the debt and deficit figures for last year were recently revised upwards as well).

Fundamentally however, an overvalued currency which prevented growth (the Escudo would have decreased in value following the original bust), combined with interest rates which were an ongoing stimulus to take on new debt, left Portugal with a decade of low growth. The resulting fall in relative living standards, compared to the rest of the EU, and the fall in tax receipts further fuelled the build up of both private and pubic debt.

Interestingly, Portugal's problems can provide some hint at what the future may hold for Greece, Ireland and possibly Spain. Even loose monetary policy and boosts in liquidity (admittedly in debt form) didn't solve Portugal's underlying competitiveness and currency problems, in fact they may have made things worse.

These lessons from Portugal's past should be heeded by those in charge. Tackling the root causes of this crisis - eurozone imbalances, competitiveness problems and the banking crisis - is of paramount importance, as is providing for all eventualities, including a restructuring and possibly even a change in eurozone membership.

Is the ECB becoming a bad bank?

Its common knowledge that the ECB has been providing massive amounts of liquidity to eurozone governments both directly (through the purchase of government bonds) and indirectly (by taking on large amount of government debt as collateral for lending to banks). The extent of this – and therefore also the implications – are less clear, mostly thanks to the ECB’s reluctance to publish any data on its holdings of collateral or government debt.

FT Alphaville highlights a note from JP Morgan, which suggests that the indirect exposure of the ECB to the Greek state is massive - and then we mean massive. JPM estimates that Greek banks have posted almost €140bn in state related collateral with the ECB (€85bn of state guaranteed bank paper, €45bn of Greek government bonds owned by Greek banks and €8bn of zero-coupon bonds which the Greek government had lent to Greek banks in 2008). Combining this with the direct holdings of government debt (thought to be around €60bn, as we noted in our paper on Greece) you get total exposure of the ECB to the Greek state of around €200bn.

That is a phenomenal amount.

Though these amounts are slightly speculative at the moment, there are some interesting and possibly disturbing implications here, particularly for those of us who believe that Greece will need to restructure its debt at some point soon (not that we’re alone, this group includes nearly all investors and apparently the IMF). This exposure to the Greek state is in the direct firing line if a restructuring occurs. First, there are likely to be large write downs on the direct holdings of Greek government bonds (at least 35% to have any significant impact on the debt burden) and secondly, the state backed paper could become close to worthless. Potential losses are still hard to quantify but would easily be upwards of €40bn.

Comparing this loss to the capital and reserves which the ECB holds, around €79bn, shows the potentially difficult situation which the ECB could find itself in following a Greek restructuring. Essentially the ECB would either have to ask eurozone governments for an injection of capital or or try to print their way back to an acceptable level of capital and reserves.

Therefore, following a Greek restructuring the ECB may have may face a difficult choice: completely ignore its primary mission (i.e. price stability) and print money or go hand in cap to governments - like the bad banks in the financial crisis - and ask for cash (almost like a bail-out).

Two questions: how in the world did the ECB allow itself to get so deep into this mess? And do German politicans/economists/opinion formers understand how incredibly exposed the ECB - once dubbed the world's strongest central bank - actually is?

Kicking the euro while it’s down

Eurozone leaders seem intent on making their crisis resolution as messy as possible. According to draft summit conclusions, seen by Reuters, the decision on how the EFSF will increase its lending effective lending capacity to €440bn will be delayed until June.

Clearly the months of pitching this week’s EU summit as the defining moment in solving the eurozone crisis were not well thought through or just wishful thinking. The markets' reaction to what is now destined to be a seriously underwhelming agreement is likely to be painful for the peripheral eurozone economies.

Discussions will now focus on the ESM, which is not due to come into force until 2013. Crisis management 101 (for the EU officials out there) – handle the problems on your plate first, then deal with the ones coming down the line. Not that an agreement has been finalised on the ESM either, with German Chancellor Angela Merkel looking to score a more gradual timeline for Germany’s contributions to the fund, probably given the increasing pressures her party is facing in this year's local elections.

Not one to be topped, Portuguese Prime Minister, Jose Socrates walked out of Parliament in the middle of possibly the most important vote in the country's recent history. According to Portuguese press reports, he left without saying a word and no-one knows if or when he will be coming back.

Well, at least its shaping up to be an eventful summit…

Saying 'Nein' To Angie

Last week's EU summit, saw the Franco-German "pact for competitiveness" - a raft of proposed rules on wages, pensions, spending and taxation to strenghten discipline in the eurozone - run into some serious opposition. Not surprising given that the plan effectively demanded that permanent, cast-iron rules, rather than votes in democratically elected national parliaments, determine key policies on spending, taxation and pensions across the eurozone.

Mariano Rajoy, leader of the Spanish opposition Partido Popular, summarised the underlying problem: “As a Spaniard, I don’t like to be told what I have to do by outsiders”.

Both the content (such as breaking the link between wages and inflation) and the process (France and Germany hammering out a deal behind closed doors with little input from anyone else) caused plenty of mutters from the other EU leaders.

The Merkel-dominated plan would lay down the new economic rules in exchange for injecting more money into the eurozone's rescue fund, but is now unlikely to be adopted in full.

Here is a round-up of what the press in the so-called 'peripheral' eurozone countries - the politically correct epithet for PIIGS - said last week about Iron Angie's ultimatim.

An article in Greek left-liberal newspaper To Ethnos argued,

The way in which decisions are being forced through in the states of the Eurozone and EU nowadays is nothing short of a coup d' état. One may or may not agree with Merkel's proposals [...] But what is absolutely unacceptable is this method of foisting these measures on the states.

In Spain, an editorial in El País criticised plans to keep salary increases below the level of inflation and argued,

The Spanish economy needs to change its growth pattern; save more and increase productivity. To achieve this, many changes are needed, and one can also discuss what Merkel proposes. But in the end, each country must choose its own formula to boost productivity.

Another Spanish daily, La Vanguardia, simply stated,

[A common] European economic policy is running. Angela Merkel is driving it.

An article in Italy's top financial newspaper Il Sole 24 Ore noted,

If all goes well, the Franco-German pact for growth and competitiveness will not make any mention of imbalance corrections for countries running excessive trade surpluses: no mention of the fact that Germany might be forced to boost its internal demand to favour growth in the rest of Europe. However, a blueprint will be provided for the gradual Germanisation of Europe [...] In other words, the European economic government always invoked by France, but all in German sauce [...] Will other eurozone countries follow? Bets are open, but if they want to stay in the euro area they will not have much choice.

In Le Figaro, Chief International Economy reporter Alexandrine Bouilhet described the Franco-German proposal as the “tree hiding the forest” , arguing,

The markets listen to it with only half an ear, not to say that they are indifferent. They are only waiting for one thing: fresh money on the table to avoid a Spanish collapse. The rest is nothing but political window-dressing made of promises that only bind those who made them…”

Chapeau!

Is EMU a new Rouble zone?

An interesting fact revealed by the Irish Independent has gone almost unnoticed.

The newspaper reported this less than two weeks ago:

The Irish Independent learnt last night that the Central Bank of Ireland is financing €51bn of an emergency loan programme by printing its own money... ...A spokesman for the ECB said the Irish Central Bank is itself creating the money it is lending to banks, not borrowing cash from the ECB to fund the payments. The ECB spokesman said the Irish Central Bank can create its own funds if it deems it appropriate, as long as the ECB is notified.

News that money is being created in Ireland will feed fears already voiced this week by ECB president Jean-Claude Trichet that inflation is a potential concern for the eurozone.

Jack Barnes, a retired professional trader comments:

This is a form of hyperinflation if you will, at least in context that a Central Bank, with no actual printing press, or a functioning bond market, has now electronically printed up new currency units for their banks without issuing debt behind these actions.

While this has happened before in history, it has not happened in the Euro currency project officially before today. This act is going to move the monetary policy of the union, to the individual capitals. The capacity to print electronic credits, with out the creation of cash currency or debt, is a new wrinkle in the economic landscape.

Citi chief economist Willem Buiter, who, as late as 2009, called for the UK to adopt the euro, has now published a paper looking at these operations. He makes a not so flattering comparison to another monetary union, which fell on hard times:

A monetary union with multiple independent centres of money creation will end up looking like the Rouble zone that survived the collapse of the Soviet Union at the end of 1991 for a bit, until it collapsed in a series of chaotic hyperinflations.

Meanwhile, Yale Phd Ed Dolan, who was a professor in Moscow from 1990 until 2001, provides some background in a new briefing, "The Breakup of the Ruble Area (1991-1993): Lessons for the Euro ":

The Central Bank of Russia claimed a monopoly on the issue of paper currency, but each of the 15 central banks of the ruble area could inflate the money supply through creation of bank credits. Each government was able to gain the full seigniorage benefit of financing its deficit through its own central bank, while spreading the resulting inflation among the whole group of 15.

(...) This gave rise to a free rider problem: Each country could use central bank credit to finance its budget deficit The resulting inflation was transmitted among all 15 member countries Each country had an incentive to act as a free rider, enjoying the benefits of credit expansion while shifting the inflationary costs to its neighbors.

Interestingly, as others before him, he sees Germany leaving the euro as the more preferable option:

It is hard for countries with weak economies to leave a stable currency area because doing so can trigger defaults and bank runs. These exit barriers do not apply to countries with strong economies that want to leave a weak, inflation-ridden currency area.

Similar inflation concerns are now forcing the ECB to choose: increase interest rates to promote a hard currency, satisfying Germany; or keep rates low to help out struggling economies on the eurozone's periphery.

Perhaps the first chapter of the eurozone crisis is over. Another one is about to begin.