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 Greek banks improving or struggling for liquidity?

Those who followed our analysis of the Greek bond buyback will remember that we warned at length that it could have some adverse effects, one of which would be to hit bank liquidity at a time when Greek banks could least afford it.

In the end Greek banks were pushed to take part by the government but their resistance (despite being reliant on the Greek Central Bank for liquidity and the eurozone for a recapitalisation) was quite telling.

In any case, data is now beginning to emerge which sheds some light on the issue but also provides plenty of questions (as always with Greece data releases are some months behind elsewhere so the latest data available is for January 2013).

Greek bank borrowing from the ECB and the Greek Central Bank (via ELA) has dropped significantly since the bond buyback at the start of December (down €21.3bn since November 2012).

 

Now, normally a sharp drop in borrowing from the ECB and ELA would be a positive thing since it suggests reduced reliance on official funding. However, in this case, we suspect that rather than improving their position, banks are actually struggling to find sufficient assets to post as collateral with the Bank of Greece to gain liquidity.

Other factors do support this argument. The Bank of Greece annual accounts show that the overall collateral pledged for central bank liquidity fell by €11.7bn in the aftermath of the bond buyback, while borrowing from the central banks fell by €7.5bn (data for January is not yet available). Furthermore, with total assets pledged for collateral still totalling €217.1bn or 50% of all bank assets in Greece it is easy to imagine that the banking sector is working under significant collateral constraints.

Are there any other potential explanations?

Well, the first would be that banks repaid their borrowings from the ECB’s Long Term Refinancing Operation (LTRO) in January. This seems very unlikely. The LTROs coincided with a period of extreme turmoil in the Greek banking sector due to the Greek debt restructuring, a period in which Greek banks could not access the ECB. Therefore, it is unlikely that Greek banks borrowed much if anything from the LTRO. Besides, if they did, it seems strange that they would give back a key source of long term funding early.

The second explanation could simply be that confidence has returned somewhat. There is some evidence to support this, not least the return of domestic deposits, which have increased by €12.1bn since November 2012. However, that still leaves a drop in central bank borrowing of €10bn which does not seem to have been filled by other sources of liquidity.

Lastly, the bank recapitalisation is being enacted, which could reduce the Greek bank demands for liquidity, although since it isn’t expected to be completed until end of April it would seem strange if the impact showed up this early on.

Overall then, there seems to be some strong evidence that the Greek bond buyback has hit the liquidity access of Greek banks, albeit not in a catastrophic way. More importantly though it has happened at a time when credit provided to the real economy continues to contract and economic growth remains some way off.

Update 16:30 13/03/13: 
@EfiEfthimiou has flagged up a good point over email. In December 2012 the ECB began accepting Greek government bonds as collateral again, this allowed banks to switch from using the more expensive ELA to standard ECB liquidity. The haircut on collateral may also be lower under standard ECB lending (we can't be certain since ELA terms are secret). This could have allowed the banks to reduce their liquidity needs and the level of collateral posted - another potential explanation then.

Greek bond buyback fallout continues

As we noted in this morning’s press summary, there have been some interesting developments with regards to the Greek banking sector.

Kathimerini reported that, according to unnamed bank officials, the bank recapitalisation may now need to be larger than the scheduled €27.5bn. The reason for this is twofold:

• First, the level of non-performing loans in Greek banks topped 24% of all loans at the end of 2012. This is a staggering amount. Keep in mind the Spanish banking sector, which has been the focus of so much uncertainty, still has non-performing loans equal to around 11% of all loans. Greece once again is in another league here.
• Secondly, as we warned at the time, the bond-buyback had a detrimental effect on the Greek banks. Even if they did not take substantial direct losses on the bonds they submitted, they have lost out in terms of future revenue (the interest from the bonds). This is reported to amount to around €1.5bn this year.

As FT Alphaville highlights, this seems a fairly clear-cut case of the negative trade off which we highlighted at length in the run up to buyback.

Needless to say, it is not make or break and the marginal effect of the buyback is still positive, albeit fairly small in the scheme of the Greek crisis. Fortunately, there is an additional €5bn set aside for such ‘unexpected’ increases in the bank bailout, so the additional cost should not disrupt the bailout programme.

We would note as a final point, that this may not be the end of the story (not just because the non-performing loans are likely to increase further) but also because we are yet to find out what impact the bond buyback had on the Greek banks’ ability to access liquidity (an issue we discussed in detail here). Again it may not be make or break, but we suspect it could be a further negative factor for Greece to deal with - something it hardly needs.

Some preliminary thoughts on the stress tests for Spanish banks: lots of optimistic assumptions...

Here is the full report (and the bank-by-bank results) from the latest Spanish bank stress test exercise. Below we provide the key points and our initial thoughts on them.

The tests put the total capital needs of Spanish banks at €59.3bn, but Spanish Deputy Finance Minister Fernando Jiménez Latorre (in the picture) just told journalists during the press conference that, assuming that Spanish banks manage to raise part of the money from other sources, the Spanish government could ask the EFSF for "around €40bn" (as we anticipated here).

Key points: 

• 14 banks assessed, 7 found to be well capitalised, 7 found to need capital injection. Total needs put at €59.3bn. This falls to €53.75bn when the mergers under way and the tax effects are considered;

• €24.7bn of the total amount is earmarked for Bankia alone, with a further €10.8bn for CatalunyaCaixa and €7.2bn for NovaGalicia;

• The adverse economic scenario assessed was: 6.5% cumulative GDP drop, unemployment reaching 27.2% and additional drops in house and land price indices of 25% and 60% respectively, for the three-year period from 2012 to 2014;

• Cumulative credit losses for the in-scope domestic back book of lending assets are approximately €270bn for the adverse (stress) scenario, of which €265bn correspond to the existing book. This compares with cumulative credit losses amounting to approximately €183bn under the base scenario.

Open Europe take: 

• The base case scenario seems overly optimistic, the adverse scenario looks more realistic - although we expect a fall in house prices of around 35% rather than the 25% assumed. The prediction that unemployment will peak at 27.2% also seems optimistic given that there is plenty more austerity and internal devaluation to come while the structural labour market reforms are yet to take effect.

• Oliver Wyman's report strongly assumes that all the previous capital buffers and loan loss provisions have been well implemented with suitable quality of assets. However, this is far from assured;

• The level of non-performing mortgage loans seems incredibly low at 3.3% currently with losses only predicted to rise to 4.1% under the adverse scenario. This number could well be distorted by forbearance (delaying foreclosing on loans likely to default to avoid taking losses) by struggling banks. It will also massively increase if unemployment and economic growth turn out to be worse than predicted;

• The levels of recovery on foreclosed assets seem a bit too positive (admittedly a wide range of between 37% - 79% losses depending on type of asset) given the continuing oversupply in the real estate market in Spain. Until the market has fully adjusted, the huge mismatch between supply and demand is likely to keep resale value on foreclosed assets incredibly low;

• These tests do look to be more intense than the previous ones but ultimately the optimistic assumptions do instantly raise questions over their credibility. The structure of the bailout request is also unlikely to enamour investors, who like to see grand gestures, however, it always positive that taxpayer participation may be limited. 

 

The ECB loads up on PIIGS exposure

Reuters MacroScope blog covers some of our updated figures on the exposure of the ECB to the struggling peripheral countries. Following the ECB’s Long Term Refinancing Operations (LTRO) the ECB’s exposure to these countries has increased significantly, without their situations showing any sign of improvement – in fact many of them are now in a worse position.

Last year we showed that the ECB exposure to the PIIGS totalled €444bn. Just a year later this has increased by a whopping 106%, to €918bn. The exposures are detailed below:

Total exposure - €917.61bn 

Exposure through lending programmes - €703.61bn 

Greece - €73.4bn
Ireland - €85.07bn 
Italy - €270bn 
Portugal - €47.54bn 
Spain - €227.6bn 

Exposure through the Securities Markets Programme - €214bn 

This gives the ECB a massive leverage ratio 38.4:1. This in itself is not the issue, more concerning is the fact that a third of the ECB’s balance sheet now resides in the PIIGS.

On top of this, while the ECB’s exposure has been rising the quality of collateral supporting this exposure has been deteriorating quickly. There are a few factors underlying this:

 - The value of the huge amount of PIIGS sovereign bonds which PIIGS banks hold has fallen while the default risk involved with them has risen quickly.
- The sovereign guarantee which backs up many of these banks (both explicit and implicit) has also become less solid as the states’ finances worsen and public outrage against bank bailouts increases.
- The risks and losses held on the balance sheets of these banks is yet to be fully acknowledged or fully realised in many cases. (For example, see our recent briefing on the massive problems in Spanish banks relating to their exposure to the bust real estate and construction sectors).
- The ECB has widened its collateral scope allowing even more opaque and harder to value collateral to be used to bank up its unlimited liquidity provision. 

That is to name but a few of the issues in play (we'll have a fuller discussion of the implications of this next week).

The real question which should be asked in all this is: how has the eurozone crisis continued to worsen despite the ECB more than doubling the money it has poured into these states?

Patently, the current approach to the eurozone crisis has failed. Even the ECB’s massive interventions only bought a short amount of time (and a lot less than many may have expected). The eurozone continues to fiddle at the edges of the crisis. All the talk of ECB lending, eurozone firewalls, IMF resources and austerity programmes fails to accept some of the fundamental flaws which underpin this crisis.

The eurozone needs to accept that there are a few structural flaws underpinning the eurozone crisis and move to correct them, not least: an endemic lack of competitiveness in the peripheral states, a structural bias towards low growth, a massively undercapitalised banking sector, mismatched monetary policy and a currency which remains grossly overvalued for many of its members. Until these issues are tackled, with both widespread political and economic will even further sprays of ECB liquidity will do little more than buy time, while further raising the cost of the potential break-up.

Update

The figures on exposure through lending programmes were obtained from the websites of the national central banks of:

Greece
Ireland
Italy
Portugal
Spain

Spanish fears stoked by genuine concerns over banks and regional government spending

We've got a piece over in City AM today looking at the reasons behind the increased financial market jitters over the state of the Spanish economy. Despite the usual EU protestations that Spanish fundamentals are sound, there are definite areas of concern present in the Spanish economy - not least, as always, the banking sector. That's not to say a bailout is assured but simply that more needs to be done to ensure the stability of the Spanish economy and convince the markets that Spain is on the path to a full recovery.

See below for the full piece and see here for our full briefing on Spain:

WITH a sense of inevitability the spotlight has landed on Spain. Though the headlines proclaimed that the Eurozone crisis has returned with a vengeance, the truth is it never left. Spain is not Greece, but, many of the market fears surrounding the economy are still both well-founded and expected. There are three major causes of concern: the exposure of Spanish banks, regional governments’ fiscal profligacy and a risk that structural reforms won’t reap benefits soon enough.

The vulnerable banking sector remains the likely trigger for any future downturn in Spain. One in five of the loans by Spanish banks to the bust real estate and construction sectors is seen as “doubtful”, i.e. at serious risk of never being repaid. Against some €136bn (£112bn) in potentially toxic loans, Spanish banks hold only €50bn in loss provisions. And things are likely to get worse. House prices have declined quickly over the past six months and may fall by another 35 per cent, if there is to be the same level of adjustment as seen in Ireland.

This is troubling, firstly, because Spain cannot afford to bail out its banks. And, secondly, because Spanish banks have been the main recent buyers of Spanish sovereign debt. If these banks don’t have the cash to buy Spanish debt, then who will? This massively increases the prospect of a self-fulfilling bond run on Spain and the chances of an ill-fated Spanish bailout.

Not to be outdone, the regions look to be harbingering plenty of problems of their own. The regions have seen the amount of unpaid debt on their books rise by €10bn (38 per cent) since the start of the crisis. The total in unpaid bills now tops €36bn. Yet again, this cost is likely to be transferred to the central government, which can ill afford it, and risks the country missing its deficit target, further fuelling market jitters. The regions are also expected to contribute 44 per cent of the planned deficit reduction this year. But with the budget still hot off the press, the largest and wealthiest regions are already rejecting Madrid’s ordered spending cuts.

The good news is that the new Partido Popular government is pushing through some much needed structural reforms. Unfortunately, it will take time for the benefits to be felt, and in the short term they are likely to increase already skyhigh unemployment while doing little to boost lagging demand.

Spain remains a serious and diverse economy, with relatively good administration and infrastructure – talk of a full bailout programme is premature. The most likely outcome is some sort of aid for the banking sector – probably with the help of the European stability mechanism. As much as we hate seeing risk being transferred to taxpayers, it might be better for Spain to swallow this bitter pill now and ask for aid for its banks, than risk it dragging the whole economy – and the euro – over the edge.

King vs the ECB - and Cameron's salient point

The Bank of England today released their latest Financial Stability Report, with governor Mervyn King making some interesting comments about the on-going eurozone crisis, saying:

"Sovereign and banking sector strains in some vulnerable euro-area economies were the most material and immediate threat to UK financial stability"

OK, really worrying but not new. However, then he goes on to say:

"Right from the start of this crisis, people wanted to believe it was a crisis of liquidity and we need to accept it's a crisis based on the build-up of large amounts of debt…The belief that we lend a bit more will never be an answer but it can buy more time to put in place a fundamental solution."

So, essentially Mr King is pointing out that weaker eurozone members suffer from a pretty severe solvency problem - not a liquidity on. It's hard not to interpret this as an outright criticism of the EU leaders' and the ECB's current bail-out strategy. Adding even more debt to the mix, won’t change anything (other than possibly buying a bit of time).

This is interesting stuff. Not only because it’s a different take to that of of the UK government - which has been peddling non-controversial statements over the last few weeks. But also because it puts him squarely on a collision course with the ECB.

And the thing is: King is absolutely right.

Moreover, when you combine the two quotes above, it suggests that the UK should be pushing for another approach to the crisis, outside of more bailouts.

The Prime Minister’s response to King's comments, coinciding with the conclusion of the EU summit, was broadly positive as well. There was some spin surrounding the EU summit of course - the played up dispute over the UK’s involvement in the second Greek bailout, as well as spats over asylum policy. Meanwhile, journalists are having a field day with Herman Van Rompuy's new, ridiculous egg-like Council headquarters (costing a mere €240 million, €100,000 only for the brochure apparently - seriously, does he not have anyone who can help him on the communication front? Or is this man running his communication efforts as well, which would perhaps explain it?).

But David Cameron did make some important comments over bank capitalisation, which actually have huge relevance for the eurozone crisis - and the efforts to find a way out of this mess:

"As I have said, and secured in these Council conclusions, we need to make sure all our banks are being strengthened in terms of their capital reserves and what they can withstand…I am confident that that is taking place in the UK. We need to make sure it takes place right across Europe and I think that's absolutely vital and what Mervyn King is saying is right."

So, despite not saying that he agreed with King’s assessment of the eurozone crisis, Cameron made it clear he’s not going to allow the watering down of the new Basel III regulations anytime soon. That should at least put banks towards the path of being able to absorb any losses when the current bailout approach comes crashing down.

As one of the eurozone's biggest weaknesses is its under-capitalised banks, the importance of Cameron's call can hardly be over-stated.