Is the eurozone crisis over? The Germans think not…

There was an interesting poll in today’s FAZ conducted by INSA for Bild on whether Germans believe that eurozone crisis is over or not.

The results were pretty comprehensive with 81% saying that they do not believe the crisis is over compared to 7% who do.

Furthermore, 34% of Germans believe that Greece is on the road to recovery compared with 39% who believe the country has not done enough to reform its economy. Clearly they remain very unconvinced by the efforts of the Greeks.

In the same vein, Eurostat this morning put out its first estimate of the debt and deficit figures for the end of 2013. As might be expected they don’t make particularly pretty reading. As the graph below highlights, the debt levels in many EU countries have continued to increase and by substantial amounts in Cyprus, Greece and Slovenia – all due to bank bailouts/recapitalisations.

With debt levels continuing to rise and the long term structure of the eurozone still developing it remains premature to cast the crisis as over - at least the Germans seem to think so.

Italian PM Letta will resign: What happens next?

Italian Prime Minister Enrico Letta has announced he will tender his resignation to Italian President Giorgio Napolitano tomorrow. The dramatic development comes after Italy's centre-left leader Matteo Renzi addressed a meeting of his Democratic Party earlier today. A few minutes before Renzi took the floor, it emerged Letta would not be attending the meeting - a clear sign of where things were going.

The three key points of Renzi's speech were:

• Letta has done a great job, but it's time to give way to a new government (that Renzi will lead);
• Snap elections now would be too risky, primarily because the electoral law hasn't been changed yet;
• The new government will aim to stay in office until 2018 - when the current parliamentary term expires.

It now seems certain that the 'staffetta' (relay) will materialise - and we expressed our thoughts on the move in our previous blog post.

So what happens next? If you're regular readers of this blog, you should know the drill by now - but just in case:

• Letta will meet President Napolitano tomorrow, and will hand in his resignation;

• Napolitano will then have to consult all the political groups holding seats in the Italian parliament. The timetable is usually announced after the Prime Minister resigns, but we reckon it could happen over the weekend; 

• After the talks, Napolitano should give Renzi the mandate to form the new government - presumably early next week;

• After holding his own round of talks with other political leaders, Renzi should then unveil the list of ministers (we'd expect a rather substantial reshuffle from the current cabinet), and should be sworn in;

• After being sworn in, Renzi will have to face a vote of confidence in both houses of the Italian parliament - which, as things stand now, should be a mere formality. 

This is all you need to know to make sense of the latest political developments in Italy. For real-time updates, you can follow us on Twitter @OpenEurope and @LondonerVince.

Italian PM Letta survives key confidence vote: What's next for Italy?

What looked like an imminent political crisis has just been defused in Italy. As we anticipated in our previous posts (see here and here), Italian Prime Minister Enrico Letta has managed to survive a vote of confidence in the Senate - the upper chamber of the Italian parliament where his Democratic Party doesn't hold a majority.

In a last-minute U-turn, Silvio Berlusconi has decided that his party would support the government after all - turning a potential showdown into a mere formality. Nonetheless, what just happened in the Italian Senate does have consequences for the future of Italian politics. Here are a couple of thoughts.

1. Letta stays on, but uncertainty remains over what his government can deliver

The first, and most obvious, immediate consequence of today's vote is that Enrico Letta can stay on as Italian Prime Minister and maintains, at least on paper, his overwhelming parliamentary majority. However, it remains to be seen what Letta and his cabinet can deliver in terms of bold, concrete measures to get Italy going again - not least because some fundamental differences between the parties forming Italy's ruling coalition will remain.

One may argue that, faced with a party mutiny ahead of today's vote, Berlusconi would have finally learnt his lesson and would think twice before triggering new crises in future. But we wouldn't rule out new coalition rows. Berlusconi is famous for his CEO-style handling of his party, and he tends to take all the big decisions on his own - which makes him a very unpredictable coalition partner.    

Another important issue is: how long will Letta stay in office for? It's no secret that both him and Italian President Giorgio Napolitano would like the current government to continue at least until after Italy's rotating EU Presidency (July-December 2014) - and then perhaps go to early elections at the beginning of 2015. This would still be much earlier than 2018, when the current parliamentary term is supposed to end.

Questions will also remain over whether, if the crisis deepened once again, Italy would really be able to gain access to the ECB’s bond-buying programme, the OMT. As we mentioned above, Letta has clearly won the day - but uncertainty remains over his government's ability to push through unpopular measures.

Crucially, the ECB has made it clear that any country accessing the OMT must have a credible government in place to enforce the necessary conditionality attached to bond purchases (very likely to involve significant structural reform and budget cuts).

2. This is not the end for Berlusconi, but he's just been dealt a hard blow 

There's another reason why today's confidence vote is significant. Looking beyond the appearances (and the last-minute coup de théâtre) Silvio Berlusconi has, in substance, seen his plan to bring Letta's government down disrupted by a rebellion from within his own party. Last weekend's decision to pull his ministers out of cabinet has therefore proved a miscalculation, and will have at least two consequences:

• Berlusconi's threats to bring the government down if he's voted out of parliament as a result of his recent tax fraud conviction are no longer credible; 

• 25 senators from Berlusconi's party have this morning announced the creation of a breakaway group in the Italian Senate, irrespective of how the rest of the party would have voted. Though far from certain at this stage, today's defectors may well decide to follow up and quit Berlusconi's party - which in turn may reduce Il Cavaliere's electoral strength.

Berlusconi has shown his resilience several times, so we are unlikely to be witnessing the end of his political career just yet - even after he's ousted from parliament. Let's not forget that polls suggest he maintains quite large public support, with the help of his control over a large swathe of the media. We wouldn't expect him to take this challenge lying down. That said, his leadership of Italy's centre-right forces has today unequivocally been put into question.

These are our preliminary thoughts. We'll continue monitoring the situation in Italy very closely, so keep following us on Twitter @OpenEurope and @LondonerVince for all the updates.

Italy plunged into fresh political turmoil: End of the line for PM Letta?

UPDATE (18:15) - Silvio Berlusconi has just come out of a meeting with MPs and Senators from his party. According to reports in the Italian media, he has outlined the following roadmap: a quick vote on the 2014 budget and a couple more economic measures (Berlusconi apparently said this can all be done in one week), followed by snap elections.

Not sure this can represent a good basis for a potential compromise with Enrico Letta's centre-left Democratic Party - not least since Berlusconi's strategy seems to imply a return to the polls without changing Italy's controversial electoral law first. We explained in our original blog post from this morning why this could be a huge gamble.

UPDATE (15:45) - Italy's Minister for Relations with Parliament, Dario Franceschini (from Enrico Letta's party) has just confirmed that the Prime Minister will address the Italian Senate on Wednesday morning and the Chamber of Deputies on Wednesday afternoon.

However, Mr Franceschini also stressed that a confidence vote after the debate is "very likely", but will ultimately "depend on how the debate will go". We think there are two possible interpretations here, depending on whether one wants to see the glass half full or half empty:

1) Mr Letta is still confident Berlusconi could backtrack on his plan to bring the government down;

2) If, based on the statements made by the various political groups during the debate on Wednesday morning, Mr Letta were to deem the confidence vote in the Italian Senate absolutely impossible to win, he may decide to skip it and tender his resignation straight away.

ORIGINAL BLOG POST (9:30)  

For regular readers of this blog (see here, here and here), Silvio Berlusconi pulling the plug on Italy's fragile coalition government was just a matter of time - especially after his conviction for tax fraud. On Saturday, Il Cavaliere ordered ministers from his party to resign and called for snap elections.

The official reason for doing so was the Italian government's inability to scrap a VAT increase planned by the previous technocratic cabinet led by Mario Monti, due to kick in tomorrow. However, it would be naïve to see no correlation with the fact that Berlusconi is to be ousted from parliament within the next few weeks as a result of his tax fraud conviction. 

So what happens next? The moment of truth will be on Wednesday, when Prime Minister Enrico Letta will seek a vote of confidence in both chambers of the Italian parliament. The key vote will be the one in the Senate, the upper chamber, where Mr Letta's centre-left Democratic Party does not command a majority on its own.

Scenario 1 - Letta survives the confidence vote in the Senate

Tough, but definitely not unrealistic. Letta needs around 20 Senators from either Berlusconi's party or Beppe Grillo's Five-Star Movement to break ranks and support him. Over the past few days, politicians from both parties have hinted at possible defections. Crucially, after tendering their resignations, four of Berlusconi's ministers have expressed reservations over their leader's decision to open a new political crisis at this stage. All this suggests Letta does have a chance of winning the vote in the Italian Senate, and staying in power with a different, albeit thinner, parliamentary majority (and after a rather substantial cabinet reshuffle).

However, this would only be a temporary fix. With his new majority, Letta could try and address a couple of urgent issues (a reform of Italy's tortuous electoral law and the budget for 2014 are the most obvious) - and perhaps plan for early elections at some point next year.  

Scenario 2 - Letta loses the confidence vote

If Letta loses the confidence vote, he will have to resign. As we explained several times, the ball would then be in Italian President Giorgio Napolitano's court. Napolitano would have to hold talks with all the political parties and then make a decision: task Letta himself or someone else with forming a new government, or dissolve parliament and call new elections.

New elections in Italy can take place no less than 45 days after parliament is dissolved. The risks of a quick return to the polls are obvious. Voting again with the same electoral law may well lead to another inconclusive outcome - meaning that Italy could be facing a few months of political paralysis at a time when the country can least afford it. As if things were not complicated enough, the electoral law is currently also being examined by the Italian Constitutional Court, with a ruling expected in early December - and is at risk of being declared at least in part unconstitutional.

This is where we are at. Clearly, none of the two scenarios would provide the medium-term political stability Italy needs to get its act together - which in itself is not great news for both the country and the eurozone as a whole. Everything will depend on how Wednesday's vote of confidence goes.

Follow us on Twitter @OpenEurope and @LondonerVince for all the updates. 

German growth leads the eurozone out of recession but can it really lead the eurozone out of its crisis?

As has been widely covered today, the eurozone exited recession in the second quarter of this year, growing by 0.3% (over expectations of 0.2%).

We posted our thoughts on this expected ‘turnaround’ in the eurozone a couple of weeks ago, so we won’t rehash them. Needless to say the figures are a positive but there is still plenty of negative data around (unemployment, bank lending to real economy, consumer confidence), so European leaders should refrain from getting overexcited.

The key point for us remains this issue of divergence. It’s worth noting that Germany and France played a significant role in pulling the eurozone average growth up. There also seems to be a prevailing logic that German growth can play a big role in pulling the eurozone out of its crisis. As we have noted before we’re fairly sceptical of this idea for a couple of reasons.

There are two mechanisms through which German growth could in theory help boost struggling eurozone countries:

• Firstly by boosting German demand for imports from these countries significantly.
• Secondly by moving Germany away from its export model (possibly through decreased competiveness) allow these countries to fill that gap and export more.

1. Boosting imports
 

(Data up to end of 2012, however imports from eurozone countries have continued to decline in 2013)

As we have discussed before, and as the graph above shows (click to enlarge), German imports from peripheral eurozone countries have decreased substantially with only Italy featuring as one of Germany’s top ten trading partners. Furthermore, imports from other EU countries have declined to 56% of total imports – with the eurozone accounting for approximately 38% of this and peripheral eurozone states a small part of this. 

Therefore, even if GDP and consumption are growing quickly in Germany it’s not entirely clear that this would have a significant knock on effect on the countries that need it most.  The Netherlands, France and Italy are the most likely to see some boost. The IMF itself noted recently that using fiscal policy to boost Germany GDP would provide limited help for the eurozone. It ultimately also depends where Germany’s economic growth comes from, if driven by its own exports or government spending the impact would be even further limited.

2. Providing space for the periphery to boost exports

The theory here is that Germany ‘reflates’ allow wages and unit labour costs to grow and focuses its economy more on domestic consumption and investment rather than exports. This allows for the other eurozone economies to step in and export more, not least because they look relatively more competitive.

However, as the graphs above show (via UBS, click to enlarge), in many cases the struggling peripheral countries do not export the same goods as Germany (transport equipment, electrical equipment, chemicals), although there is some overlap on food and financial services. In any case, it’s far from clear that the struggling peripheral countries would be able to step into any breach left by Germany (particularly with heavy competition from emerging markets). Furthermore, many German exports used component parts from elsewhere in the EU, so decreasing them could actually have negative knock-on impact in certain sectors.

Another point worth keeping in mind is that a rapidly growing Germany would put added strain on the one-size-fits-all policy of the ECB. With the ECB now forecasting that interest rates will stay low for some time, if Germany continues along this growth path it may not be too long before the Bundesbank becomes concerned about the monetary policy being too lax.

It almost goes without saying that strong German growth is a good thing for the eurozone generally (breeds confidence and helps encourage investment) and strong economic growth should be the target for all countries. However, as the points above demonstrate, this does not mean it will be enough to drag the eurozone out of its crisis (i.e. it may be necessary but it is far from sufficient) and is certainly no panacea. The key issues to address remain the structural flaws in the eurozone and the lack of competitiveness within many of the peripheral economies.

Turning a corner in the eurozone? Not quite yet...

There has been a lot of chatter this morning about the eurozone recession coming to an end following the release of the latest Markit Purchasing Managers’ Index (PMI) - a set of indicators used to measure the economic health of the manufacturing and service sectors. The index reached the highest level for 18 months and pushed past the point where it was continuing to decrease (see the relevant graphs below).

These results are clearly positive, but it seems that some commentators have been getting a bit ahead of themselves in declaring the recession and troubles over. Here are a few points to keep in mind:

• The average for the eurozone has only just pushed into the positive territory and remains closer to being flat. This suggests that GDP may have stopped contracting but has flattened out rather than returning sharply to growth.
• Furthermore, this is an aggregate figure. In fact, the PMIs for many countries are still contracting – France included (see right-hand graph above). Given that this crisis is much more about divisions between countries than the aggregate as a whole, such gaps remain important. In fact, with Germany posting strong results, the gap between the strongest and weakest may grow. This could create tensions for future ECB policy.

• As the graph above shows (courtesy of Commerzbank) although some of the peripheral countries are doing better, concerns are now growing about some of the semi-core and even core members, such as France. The economic sentiment and outlook in these countries remains worryingly bleak. For France in particular, questions need to be asked about how useful the PMIs are as an indicator give that they have been contracting for some time but GDP has remained fairly flat – i.e. they have detached from one another. It’s not clear any turnaround in PMI will show up in GDP.
• PMIs represent the private sector. Other components of GDP, in particular public spending and investment generally continue to fall. Even if the private sector is growing, it may not yet be enough to offset this. In many countries the private sector growth is also tied in close with export growth and an external recovery – this remains fragile (see for example the corresponding PMIs for China which fell sharply).
• Other indicators also suggest that the difficult environment will continue for some time. The ECB’s bank lending survey also out today highlighted that credit to the real economy continues to contract, albeit at a slower rate. Consumer confidence released yesterday did show a large jump but remains well below its historical average in depression territory.
• A slight turnaround was widely predicted for the second half of this year and so may be largely priced in when it comes to borrowing costs and stock markets (not least because the latter seems to continue to outstrip the macroeconomic fundamentals). 
• Finally, it's worth remembering that political uncertainty in southern eurozone countries can return at any point in time these days (see our previous blog posts for the latest from Portugal, Italy and Spain).

All that said, it is easy to pick holes in any single piece of data. The positive turnaround is good for the eurozone, but it is only one indicator and time will tell whether it can amount to a sustained improvement. Given the many obstacles which the eurozone has failed to address this still seems a very uncertain prospect to say the least.

Debt problems in Europe extend beyond the headline figures

On Monday, Eurostat released its latest figures on public debt to GDP, which soared to a record of 92.2% in the eurozone in the first quarter of this year. Of all the eurozone members, only Germany and Estonia were able to reduce their debt levels in the first three months of 2013, while in total five eurozone members had debt-to-GDP over 100%.

High government debt is obviously a well-covered issue and a well-known problem in the eurozone. However, the debt problems extend well beyond this simple figure - we've touched on this previously, when looking at the level of financial sector debt and the need for a eurozone banking union. Another potentially interesting aspect of the debt problems relates to what is known as 'implicit debt'. This is an estimate of the future debt which states will accrue including contingent liabilities such as pension payments and welfare payments (many of which are, at this point, unfunded). 

In that vein, we thought it would be worth looking back at an interesting study produced by German think tank Stiftung Marktwirtschaft in coordination with academics at the University of Freiburg at the end of 2012. They've had a go at calculating the level of 'implicit debt' in the EU and what it means for debt sustainability. The results are laid out in the table below.

('Implicit debt' is calculated using data on future GDP growth as well as on the long-run change in age-dependent expenditure, using the European Commission’s reports on ageing, all done assuming no policy changes and put into 'present value' terms).

As with any such calculations, there are numerous assumptions and we must be wary of drawing grand conclusions, but the results provide some interesting points nonetheless. At the bottom of the debt sustainability ladder, we see the usual suspects such as Greece, Cyprus, Spain and Ireland (raising some questions about how effectively it is really recovering from its crisis). Slovenia, a country which we warned may be in line for a bailout, also finds itself in trouble by this metric. Surprisingly, Luxembourg fares very badly; the authors suggest this is down to its "generous" pension system which has not been overhauled to deal with future demographic developments.

It may also surprise many that Italy ends up top of the table. The authors suggest that this is due to the fact that the country "expects only a small rise in age-dependent expenditures as a proportion of GDP." Italy admittedly made quite an effort already in reforming its pension system (in the 1990s and more recently under Mario Monti's technocratic government) but this outcome does seem fairly optimistic, not least because it is reliant on Italy maintaining a long term growth level of close to 2% per year.

All that said, another study, by Société Générale, on the topic of "unfunded liabilities" relating to pension and welfare costs, places Italy's at 364% debt of GDP suggesting it is better off than France (549%) or Germany (418%). Similarly, by the SocGen method, Spain would only have a burden of 244% to GDP, showing that a lot depends on the precise calculation and what is included. Perhaps a bit worryingly, the UK is doing worse than most eurozone countries in both calculations.

According to Johan Van Overtveldt, the editor-in-chief of Belgian magazine Trends who flagged up these results, "These figures are taken very seriously by the ECB". With regards to Italy, he warns that "an increased interest rate or a continuing recession (or a combination of the two) can quickly and drastically overturn this positive image".

In any case, these figures provide some added depth to the on-going debt issues in Europe and debatedly provide a slightly more complete picture than the simple headline debt to GDP figures. As we have noted before, though, this is simply one aspect of the varied and complex eurozone crisis which extends beyond just government debt to the banking sector and international competitiveness (to name but a few areas).

More of the same expected from the ECB despite eurozone economic malaise

The ECB holds its monthly meeting tomorrow. Below we look at the main topics of discussion, with the ECB weighing some important decisions.

Could the ECB cut its main interest rate again?

• Possibly. It is certainly considering it. As with last month, growth and inflation have remained subdued, providing further incentive and scope for the ECB to cut rates.
• There has not been a significant downturn on either front however, meaning many do not expect further action.

The ECB is considering a negative deposit rate
Most reports suggest the ECB Governing Council is split on this issue. At the least this means it is unlikely to push ahead with it. We also believe the problems and complications outweigh the benefits. There has been much written about this but below we summarise the key points.

Logic: banks are now charged for holding large excess reserves (deposits) with the ECB, this will hopefully encourage them to make loans on the interbank market and make more loans to the real economy rather than holding the money at the ECB.

In favour:

• Banks and investors look for higher returns and begin lending cross borders again. This aids financial integration and could help tackle other issues such as the large Target 2 imbalances.
• Increases the amount of times money is circulated through the economy (the velocity of money) as lenders try to avoid getting stuck with excess cash. This could in theory help boost inflation and growth.

Against:

• Contrary to prevailing logic it could actually cause a drop in liquidity. As excess reserves become more expensive banks begin repaying loans they have taken from the ECB. All the while they are deleveraging (may even speed it up), causing less money to flow to the real economy.
• Rates could actually rise for a number of reasons. Larger number of weaker banks forced onto the interbank market. Banks may simply look to pass on increased costs to consumers.
• If banks do not pass on costs or deal with them, then profits will be hit – in many cases they are already worryingly low.
• Could increase the flood of money to safe assets, particularly from the core eurozone countries. The return on these would become even more negative, increasing their costliness and driving divergence with the rest of the eurozone.
• The large money market fund industry, which plays an important role for liquidity in bond markets, could struggle to stay afloat since it relies on small positive returns on safe short terms assets (see above points).
• The euro is likely to weaken, this combined with the other effects could cause a large outflow of cash to other parts of the world, exacerbating problems.

What about all the talk of boosting lending to small businesses?
This focuses around the creation of a new market for securitised loans to small businesses. The logic being: banks make these loans, package them together into securities and then sell them on to other banks and investors. There is a clear demand for quality assets which provide a decent return meaning there could be demand for such securities.

However, the ECB has backed away from grand plans on this issue. As we pointed out previously it was always very hesitant about purchasing such securities itself, with the Bundesbank in particular opposed to such action.

More of the same seems likely
With things ticking over the ECB is likely to hold off on any further drastic action at its meeting tomorrow. It will continue to emphasise that monetary policy will remain loose for some time (the concept of forward guidance which it began to adopt last month to some extent). It may also put more flesh on the bones of schemes to work with the European Investment Bank (EIB) to boost lending to small businesses. Some easing of the collateral rules as we predicted last month is also a definite possibility.

As we’ve said before, the ECB continues to look constrained. It does of course have a few more tools, however, they are in many cases quite extreme and have potential side effects. These are best suited to very extreme scenarios (euro break-up) rather than the wider malaise and long term endemic crisis which the eurozone now faces, particularly given that often (as we are now seeing with banking union) any ECB action sparks complacency and inaction on the part of politicians.

ECB increasingly likely to cut rates but running short of tools to help the eurozone economy

The ECB looks set to cut its main interest rate by 0.25% to 0.5% on Thursday (while keeping the deposit rate at 0% due to concerns about distortionary effects of negative rates).

Why is the ECB considering cutting rates?

• The obvious answer is that the crisis is clearly dragging on and the eurozone economy is struggling. But, that has been true for some time, so why now?
• Economic activity has been particularly bad (see right hand graph below), while forecasts have been continuously downgraded.
• In particular, annual inflation has dropped well below the ECB’s target of 2%, while unemployment has continued to rise (left hand graph below, click to enlarge).

Will it have any impact?

• Not really. On the margin it will help reduce costs for those banks which borrow heavily from the ECB and consumers with variable rate loans and mortgages – but the impact will be very limited.

• The usual mechanism through which a rate cut is transmitted to the market is broken. See for example the overnight lending in the eurozone. It remains at a very low levels. That said, rates are also at record lows. Why is this? Well, most likely because only the strongest banks are borrowing on these markets. For this reason the cut will not filter through to where it’s most needed since lending rates are already completely detached from it and focus more on the risks of the banks involved.

• As has been well documented, rates in the south and the north are also significantly different, particularly in terms of lending to businesses. Clearly, these have also diverged from the current ECB rates which are already incredibly low. Cutting further is unlikely to impact this.

What other tools does the ECB have?

Communication: ECB indicates willingness to keep monetary policy loose and step in to aid markets if needed. This has been used effectively by the Fed.
Probability: High, especially in coordination with rate cut.
Effectiveness: Minimal boost since it is already being pursued to some extent, more to reassure markets.

Easing collateral rules: ECB widens the range of assets which it accepts as collateral in exchange for its loans. May also decrease the 'haircut' applied to the value of the loans (thereby increasing their worth as collateral). This is likely to be targeted on SME loans and securities made up of SME loans.
Probability: High, if not this month then in June, particularly if economic data continues to be poor. Effectiveness: Limited, could help bank funding but unlikely to boost SME lending significantly. More risk taken onto ECB balance sheet, likely to widen divisions with Bundesbank. Has been done previously and had little impact.

Outright purchases of SME loans and securities: ECB purchases securities of bundled SME loans, similar to the purchases it made under the Covered Bond Purchase Programme and the Securities Markets Programme.
Probability: Very low. Draghi has previously suggested he sees it more as the job of institutions such as the EIB to help SMEs. Furthermore, the level of SME ABS is limited since they rely heavily on bank loans for funding (another reason why the ECB believes a rate cut could help, at least in theory).
Effectiveness: Limited, especially given that the market for such products is not huge. It would also increase the risk taken directly onto the ECB balance sheet (more so than easing collateral) and would provoke an outcry in Germany for overstepping the acceptable level of central bank intervention. Furthermore, such direct purchases are much harder to unwind than loan related policies which expire naturally, selling off these assets will be tough.

A version of the UK 'Funding for Lending' scheme: not really an option for the ECB at this time, contrary to popular belief. The various national regulations and structures aside it is practically impossible since the ECB already applies full allotment (unlimited lending).
Probability: Very low.
Effectiveness: Potentially counterproductive as the ECB would need to end its programme of full allotment in order to then make liquidity dependent on the amount of loans made by banks.

These are to name but a few options being reviewed currently. Other options such as working with the European Investment Bank to promote SME lending would need political assistance, while options such as 'Quantative Easing' aren't viable for the ECB, as we discussed here.

So for all the talk of the rate cut, it will likely have a very minimal impact. The ECB could look to combine it with other policies but the painful reality is that, when it comes to boost lending to the real economy, the ECB has very few options. Constraints from the Bundesbank and concerns over the progression to banking union mean the ECB will likely continue to put the onus on governments to make reforms to boos the economy.

Italian PM launches opening salvo against austerity - but where will the cash come from?

The new Italian Prime Minister Enrico Letta announced his first raft of policies in his first speech to the Italian parliament yesterday. The speech was strong on anti-austerity rhetoric but short on details of how his new approach would be funded - illustrating that ever-so-relevant dilemma in the eurozone (and elsewhere): it's easy to criticise austerity, much harder come up with alternatives. Here are the key points:

·    The government will scrap up to €6bn worth of tax rises, although Letta provided no detail about how this funding gap would be filled. Much of this move was motivated by Silvio Berlusconi’s insistence on scrapping a new housing tax which was laid out as a precondition for the formation of the grand coalition

·    Some phrases which will make German Chancellor Angela Merkel wince, such as: “We will die of fiscal rigour alone. Growth policies cannot wait any longer”, “[Europe faces] a crisis of legitimacy” and there is a need for a “United States of Europe”.

·    Letta believes Italy’s welfare system is inadequate and will look to broaden it to provide further help to women, young people and temporary workers.

·    Businesses will also receive tax incentives to hire young workers.

·    Again no details on how such policies will be funded. La Stampa reports that all in, the “Letta Agenda” could cost €20bn. He made no mention of privatisations or the sorely needed reforms to the labour and product markets to make Italy more competitive.

·    Letta did stress that Italy will meet all of its EU commitments and targets.

·    He set himself and the new government an 18 month window in which to achieve the some success in turning around the economy or “face the consequences”.

·    Promised to reform the electoral law and cut MP’s pay.

A very interesting opening salvo from Letta. In fact, not too dissimilar to French President Francois Hollande’s early comments regarding austerity – we can’t help but wonder if his enthusiasm and/or success will wane in a similar way.

One thing that is clear from the speech is the continuing power of Silvio Berlusconi (as we previously noted). La Stampa suggest up to €12bn of the cost of the ‘Letta Agenda’ actually comes from Berlusconi’s demands, while following the speech Angelino Alfano, the new Deputy PM and key Berlusconi ally, said, “I share the words of Enrico Letta’s speech from the first to the last. It is music to our ears.” Meanwhile, Berlusconi also took the opportunity to this morning ramp up his own rhetoric against austerity, calling for the new Italian government to “renegotiate its deficit commitments” with the EU.

All of this sets an interesting tone and background for Letta’s first meeting with Merkel which takes place this afternoon. As we have noted previously and at length, the key question surrounding this whole austerity debate remains, if not through cuts, then who will pay for the party? Germany and the ECB certainly aren't ready to foot the bill indefinitely and while market sentiment is positive now, it likely could not withstand a new spending spree in a country with a debt-to-GDP of 120% already. We suspect Merkel may make just that very point...

IMF sees a mixed outlook for Europe - calls for more ECB action and a fiscal union

The IMF today released its latest World Economic Outlook forecasts. As usual the forecasts are not overly different from the previous ones - published in October last year - but there are a few interesting points.

The map above gives a pretty good feeling for just how bad Europe is doing relative to the rest of the world at the moment (click to enlarge).

The IMF warns about the risks of complacency and lack of  implementation of reform and austerity measures in the eurozone, something we touched on here:

Amid reduced market pressure and very high unemployment, the near-term risks of incomplete policy implementation at both the national and European levels are significant, while events in Cyprus could lead to more sustained financial market fragmentation. Incomplete implementation could result in a reversal of financial market sentiment. A more medium term risk is a scenario of prolonged stagnation in the euro area.

This seems to be clear reference to the banking union and the creation of a cross-border resolution mechanism to deal with banking crisis such as the one seen in Cyprus. This is a valid concern - there is huge uncertainty over the banking union.

The IMF also notes that while current account adjustment has been progressing in the eurozone it is not clear whether it is simply cyclical or the result of deeper reform:

Current account balances of adjusting economies have improved significantly, and this improvement is expected to continue this year. This increasingly reflects structural improvements, including falling unit labour costs, rising productivity, and trade gains outside the euro area. But cyclical factors also play a role, notably layoffs of less productive workers, and would reverse with eventual economic recovery.

Further to that point, there is also the interesting table below showing that Greece, Ireland and Spain have had some success in reducing unit labour costs (change is difference between the dot and the diamond). Greece mainly through cutting labour costs but the others also through increasing productivity. But there is some way to go yet, while countries such as France and Italy have made little to no adjustment. It's also worth keeping in mind that, while Portuguese ULCs have fallen from their peak, the trend and some of the fall has now been reveresed.

In addition, there are continued signs of a split in policy approach between Germany and the IMF. Comments such as these are unlikely to go down well in Germany:

Room is still available for further conventional easing, as inflation is projected to fall below the European Central Bank’s target in the medium term.

Greater fiscal integration is needed to help address gaps in Economic and Monetary Union design and mitigate the transmission of country-level shocks across the euro area. Building political support will take time, but the priority should be to ensure a common fiscal backstop for the banking union.

We'd have thought, after three years of being exposed to the politics of the troika, the IMF might be a bit more sensitive to the political intracacies of the eurozone crisis. However, it does highlight that the fundamental choice facing the eurozone has not gone anywhere..

Who’s next in line in the eurozone crisis? Portugal and Slovenia are the prime candidates

In anticipation of tomorrow's eurozone finance ministers meeting (which will discuss finalising the Cypriot bailout and potentially extending the bailout loans given to Portugal and Ireland) Open Europe has published a new briefing looking at who might be next in the eurozone - our prime candidates are Portugal (for the second time) and Slovenia.

Key points

Both Portugal and Slovenia could need external assistance of some sort.

Portugal 

• Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. 
• By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again – exactly the sort of imbalance the eurozone is seeking to close. 

• In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the country’s constitutional court has ruled against public sector wage cuts – a key plank in the country’s EU-mandated austerity plan – while the previous political consensus in the parliament for austerity has evaporated.
• In combination, it will be increasingly difficult for Portugal to sell austerity at home and consequently to negotiate its bailout terms with creditor countries abroad.
• Portugal may well need some further financial assistance before long. It is unlikely to take the form of a full second bailout, but could involve use of the ECB’s OMT bond-buying programme, assuming Portugal can return to the markets fully beforehand (even briefly). 

Slovenia

• Slovenia is not Cyprus – in fact it is much more like Spain. Its banks are significantly undercapitalised with toxic loans now standing at 18% of GDP. Banks only have provisions to cover less than half the potential losses resulting from these loans.

• At the same time, a heavily indebted private sector is now desperately trying to get debt off its books, which alongside continued austerity and lack of investment, have caused growth to plummet.
• Though a full bailout is unlikely, the country could soon need an EU rescue package worth between €1 billion and €4 billion (between 3% and 11% of GDP) to help restructure the country’s bust and mismanaged banks.
• Such a plan is likely to include losses for shareholder (bail-ins) but, unlike in Cyprus, it may not hit large (uninsured) depositors and there will be no attempt whatsoever at taxing smaller (insured) depositors.

To read the full briefing, click here.

Are Cypriots really wealthier than Germans? And is there some great hidden wealth that southern Europe can tap into?

Yesterday, the ECB released its first survey on household wealth, which produced some surprising results – not least that Germany (on paper) seems to have one of the lowest levels of median wealth, below that of bailed out countries such as Cyprus and Greece. With the German anti-bailout mood on a high, this kind of stuff is poltically quite explosive - and it was all over German press this morning.

But what about the actual survey? Undoubtedly an important effort to increase the level of data on this aspect of the eurozone economy (important for spotting future crises) but the survey itself suffers from some serious flaws.

Much has been written about this already so we won’t regurgitate all the arguments but here are the key flaws as we see them:

• Much of the data comes from 2010, with some even going back as far as 2008. This makes cross country comparisons tricky (due to distortions from the crisis) but also means that the fall in wealth in the non-core eurozone countries will not be picked up by the data.
• Households are much larger in the southern countries – particularly with more working adults living under the same roof.
• The key distortion comes from the huge disparity in home ownership, it reaches levels around 80% in southern countries compared to 44% in Germany. Not only have house prices fallen significantly since 2010 in the southern countries but they have much further to fall. The point being that these prices remain inflated from the bubble (partly due to bank forbearance and slow adjustment), meaning that the ‘wealth’ they represent is not really there (see more on this below).
• As Luxembourg and Cyprus demonstrate the influence of large financial sectors and huge foreign investments can also have a significant distortionary effect on the figures.
• Various levels of wealth inequality across the economies also skew the figures.

Even with those points in mind though, some have argued that this survey demonstrates that there is huge wealth in the southern countries and that they should not therefore be receiving bailouts.

So why can't this 'wealth' in southern economies simply be tapped to help fund struggling governments? Well, it may not be that simple. Consider the below:

• A government decides it wants to tap into the ‘wealth’ of its citizens. Since much of this is home ownership, the best way to do this would be a property tax on the value of homes (this could equally be extended to other assets as a wealth tax) – say around 5% for illustrative purposes here.
• The government institutes the tax, but people struggle to pay because, as the survey showed, despite high ‘wealth’ they are struggling with income and cash flows. Many households are also heavily indebted and in negative equity on their mortgages.
• People across the country rush to sell their houses to avoid the impact of the tax. There is little new demand (foreigners certainly don’t want to invest), so the influx of supply cause house prices to crash.
• The tax instantly fails to receive much revenue, but the knock-on effects are worse. Many people are pushed into insolvency and default on their mortgages and other loans.
• Domestic banks (large in many of these countries) are hit hard by this and see their losses spiral. They reduce lending further, harming economic growth and forcing business to lay off more workers.
• Some banks may even need to be recapitalised, something which the government can ill afford and may possibility prompt a bailout request (what we were trying to avoid in the first place).
• Added uncertainty and depressed economic outlook push up government borrowing costs.

Admittedly, this is an extreme scenario (it also works best applying it to a country such as Spain). But it serves to highlight the point that, much of this ‘wealth’ is left over from from the previous boom. This has long been clear to many, including us, who have predicted house prices will fall further in countries such as Spain (which the Commission also said today in its report on macro-economic imbalances) – thereby eroding this wealth. Tapping into such ‘wealth’ is incredibly difficult, since when you move to catch it, it evaporates.

That banks in many of these countries have been pushing forbearance (delaying foreclosure) is further evidence – if this wealth existed in the housing market surely they would have been better of forcing foreclosure and seizing the assets (admittedly some legal questions but the broad point stands). Furthermore, public assets sales such as those pursued in Greece look like great revenue sources on paper but in practice have produced limited success, partly due to lack of demand.

There are plenty of arguments against taxpayer-backed bailouts - moral hazard, political divisiveness, debt sustainability problems, inefficiency and unfairness (to name but a few) - without over-reading this survey.

Cyprus closes the shutters as it announces capital controls

Some more details coming out about the much talked about capital controls in Cyprus (details via @MatinaStevis and RANsquawk):

• Will include limit on cashing cheques (but will be able to deposit cheques).
• Time fixed deposits will not be able to be redeemed during the period of capital controls
• Credit card transactions capped at €5k per month
• Limit to cash transfers outside Cyprus of €3k per person per trip.
• Applies to all bank accounts
• Valid for 7 days from Thursday, will then be re-evaluated.

We have already noted that these controls are pretty severe and have the potential to have a substantial impact on the economy. Below we list a few more thoughts:

• The fact that they are focused on limited external flows rather than internal transactions could be positive as it may help avoid a massive liquidity crunch in Cyprus.
• That said there could still be a very quick withdrawal of funds from banks, with people keen to hold cash instead. This could further destabilise the banks.
• Removal in 7 days seems optimistic, for two reasons. Firstly, the bank restructuring and recapitalisation may not be completed by then. But more importantly, the fears which would motivate massive outflows go further than just the banks. People will look to move money out of Cyprus because the financial sector has been massively shrunk and no longer looks an attractive investment. Furthermore, the economy looks consigned to a long period of economic contraction and its debt load may quickly become unsustainable. Lastly political unrest may grow. None of these motivating factors will be gone in a week.
• The lack of limit on cash withdrawals is a positive, although this could quickly change, especially with demand for cash likely to sky rocket.
• Many companies still use cheques in Cyprus, not least to pay employees, so limiting them could hamper the normal functioning of business. That said, since they can be deposited, this is mitigated a bit, although that only holds as long as people trust that they can access deposits - not clear they do at this stage.
• According to this via Zerohedge, any commercial transaction above €500 which sends money abroad will need to be proven to be in line with usual business practice. This will introduce a significant amount of time consuming paper work into the life of many everyday exports and importers. 

We’ll update the blog with more thoughts as more details become clear.

You want contagion…I’ll show you contagion…

Everyone, including us, has commented at some point this week about how calmly markets have reacted to the situation in Cyprus.

Cue Dutch Finance Minister Jeroen Dijsselbloem.

From his interview with Reuters:

"What we've done last night is what I call pushing back the risks…If there is a risk in a bank, our first question should be 'Okay, what are you in the bank going to do about that? What can you do to recapitalise yourself?'… If the bank can't do it, then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalising the bank, and if necessary the uninsured deposit holders."

"If we want to have a healthy, sound financial sector, the only way is to say, 'Look, there where you take on the risks, you must deal with them, and if you can't deal with them, then you shouldn't have taken them on’”.

"The consequences may be that it's the end of story, and that is an approach that I think, now that we are out of the heat of the crisis, we should take."

"We should aim at a situation where we will never need to even consider direct recapitalisation…If we have even more instruments in terms of bail-in and how far we can go on bail-in, the need for direct recap will become smaller and smaller.”

"Now we're going down the bail-in track and I'm pretty confident that the markets will see this as a sensible, very concentrated and direct approach instead of a more general approach".

We’ve bolded the key quote. Essentially, he saying the Cyprus deal might be a template for other bank restructurings across the eurozone (although he seems to be trying to row back from this a bit).

Now, we’re not saying we disagree with his points and we certainly agree with the sentiment of his comments – banks should be able to shoulder their own risks and if they can’t they should have plans for winding down and deleveraging. This is why we’ve long argued for things such as living wills for banks.

Let’s be clear, banks should be responsible for their own risks. That said, if you go round telling markets all week that Cyprus is unique and specific and all year that a banking union is on its way with an ESM backed recap fund, they aren’t going to take kindly to abruptly finding out otherwise.

It all just seems a bit strange and a bit clumsy - to put it mildly. Sometimes for better or worse, markets need to be handled with kid gloves.

Contrary to his expectation that markets would see it as “sensible”, they have reacted wildly. Spanish and Italian stock markets have swung into negative territory after being up for the day, led by their banks taking a hammering, figures via @suanzes:

Ibex35: -2,68%. BBVA (3.97%), Bankinter (-4%), CaixaBank (-2,44%), Banco Popular (-4.147%), Sabadell (-3,83), Santander (-3,27%)

As we have said before, we never quite bought that Greece, Cyprus or anyone was entirely unique, though with Greece eurozone leaders definitely could have got away with it.

Where does this leave plans for banking union and eurozone integration? We’re hesitant to say tatters, but it’s not looking great.

Full circle in Cyprus

Update 13:15 22/03/2013:

Thinking about the plan in more detail, it occurred to us that this may amount to trying to burn the larger depositors twice. As we noted in today's press summary, the plan essentially is to move all the bad assets to a bad bank, along with the large uninsured depositors (€100,000+). These assets would then be wound down or sold off at a large discount with the depositors footing the bill (and taking losses of 20% - 40%). This, along with the merging of Bank of Cyprus and the good bank, is how the recapitalisation costs will be reduced by €2.3bn.

So, the large depositors will take significant losses here and yet may still face a large deposit tax as well? That seems to be pushing the boundaries to us, although it is not impossible. Cyprus would not recover as destination for foreign investment for some time. One way to structure this could be for the tax only to be applied to depositors above €500,000 (as we suggest below) and the bad bank to apply to all uninsured deposits. Obviously, the bad bank scheme also only applies to Laiki bank, but as the second largest Cypriot bank it is still likely to account for a large amount of big deposits.

Still this could see larger depositors taking up to 50% hits in some cases. We can't imagine Moscow would take that one lying down, especially given comments earlier in the week...

****************** Original Post *********************

It now seems we have come all the way back round to the deposit levy as a solution in Cyprus. Overnight, the EU/IMF/ECB Troika rejected the plans for a Cypriot solidarity fund, particularly one based on pension assets and gas reserve revenues (which German Chancellor Angela Merkel specifically spoke out against).

The bank restructuring plan does seem to be holding water for now, so this has at least reduced the money Cyprus needs to raise by €2.3bn. Unfortunately, though, that still leaves €3.5bn to be found. As we noted a week ago, there are few options for doing it – and it slightly worries us that Cyprus and the eurozone are only just realising this.

Inevitably, that has led us back to a deposit levy. Fortunately, with the amount of money needed reduced, a new version can focus on larger depositors – which is reportedly what was originally proposed by the Troika last week. Barclays has a useful table on the breakdown of deposits (via @FGoria):

Going from these figures, a 12.2% tax on deposits above €500,000 would yield the €3.5bn necessary. A 9.46% tax would also be sufficient if applied to all depositors over €100,000.

Either of these options would probably be acceptable to the Cypriot parliament. Sources suggest that the Democratic Party (DIKO, Cypriot President Anastasiades's junior coalition partner) has indicated its support for such proposals, which would bring the government up to 28 votes – so potentially needing only one more.

There are plenty of pitfalls left, but we may get a vote this evening. That said, noises from the Troika earlier suggested they could take the weekend to review the bank restructuring deal.

As has been the case for the whole of this week, uncertainty seems to be the order of the day. One thing we can take away is that a deal may be inching closer…

How might a revised Cypriot bailout deal look?

Update 11:00 GMT 18/03/2013

Sources told Spanish news agency EFE that the Cypriot government and the Troika have agreed to cut the levy on depositors with less than €100,000 to 3% and and increased the levy on those with more than that to 12.5%, but we haven't seen this confirmed by anyone else so treat with care.

Update 09:15 GMT 18/03/2013:

The WSJ is reporting that Cyprus could seek a further division amongst uninsured depositors (which @MatinaStevis tweeted already yesterday). According to the paper, the Cypriot government is pushing for 3% on below €100,000, 10% on between €100,000 to €500,000 and 15% on €500,000+. There are no clear figures on how much each individual levy will raise, although Germany is said to be open to the idea as long as the total of €5.8bn remains.

The Cypriot parliament will vote on the deal at 2pm GMT, with eurozone finance ministers due to have a teleconference at some point later this afternoon.

Original post

As we reported yesterday, the Cypriot government is now scrambling to renegotiate the deal which has created such an outcry in Cyprus. Germany and the IMF will not budge on the headline figure or that the money must come from a deposit levy (the only option to raise this sort of cash anyway), however, they do not mind which depositors pay it or at what rates.

This has led to suggestions that the rates could be adjusted to increase the cost on large uninsured depositors and reduce the impact on smaller insured depositors – this would probably be both legally and politically more acceptable.

So how could it be structured? Well, Cyprus has around €30bn in insured deposits below €100,000 and €38bn of uninsured deposits above €100,000. See table below for potential structures (click to enlarge):

Option 1 seems to be what is currently under discussion. Option 2 might be politically popular, although the impact on business and investment could be significant. One thing that is clear, as we have repeated over the weekend, is that this deal remains in flux.