27 March 2013

Global Strategy
Alternative view
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Global Strategy Weekly

The eurozone is working just fine.as far as Germany is concerned
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

In the wake of the Cyprus debacle, Im going to tackle the sensitive subject of eurozone bailouts. For me the increasing belligerence of creditors and debtors underlines why I think the eurozone will ultimately break apart. Kicking the can down the road is not helping. Time is not a healer - it is a killer. And what can we learn now from the fate of the East German MZ motorcycle?
We recognise that some readers dont always like our frank analysis of economic and

market conjunctures but we say what we see without fear or favour. Hence during the Japanese lost decade we repeatedly heaped derision on the incompetence of their policy makers who seemed to take every opportunity to snatch recession from the jaws of recovery. And during the mid-noughties we tried as hard as we could to get readers to share our view, to little avail, that Alan Greenspan was totally incompetent.
We have chosen our words very carefully when analysing the eurozone conjuncture, but

Global asset allocation

% Equities Bonds Cash
Index Index neutral SG Weight

we have been clear that we expect the eurozone to break apart. We will not repeat the argument yet again but only highlight that the deflationary wheel on which the peripheral countries are being broken will in my view lead to increasing fractious relations between both debtor and creditor nations. Debtors will keep missing deficit targets due to high fiscal multipliers and creditors will have to repeatedly put their hands in their pockets.
Most economic analysis concludes, probably correctly, how much more costly it would

30-80 20-50 0-30

60 35 5

30 50 20

Source: SG Cross Asset Research

be for either a creditor or debtor nation to leave the eurozone system compared to struggling on within it. Indeed for Germany, despite becoming increasingly irritated by having to dip their hands into their rapidly fraying pockets, the crisis in the eurozone has been accompanied by the lowest unemployment rates since before re-unification in 1990 (see chart below we wont rehearse the very valid argument that Germany enjoys an extreme currency undervaluation within the eurozone umbrella). For the German worker with 5.3% unemployment it is a case of crisis, what crisis? But the argument about whether a country will leave the eurozone will not ultimately be an economic decision. Leaving the eurozone will be a decision based on the politics of depression.
Where else is unemployment substantially below Great Moderation lows, other than in Germany?
12 12

11

11

Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

Global Strategy Team

France
10 10

Eurozone
7 7

Germany
5 00 01 02 03 04 05 06 07 08 09 10 11 12 5

Source: Datastream, Eurostat, (H/T Joe Weisenthal, Business Insider)

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Please see important disclaimer and disclosures at the end of the document

Global Strategy Weekly

Ben Bernanke would be proud of the Troika (IMF, ECB and European Commission). The Fed Chair thought he was being reasonably successful in using QE to suppress yields and drive savers out of cash deposits into riskier assets. The Troika in its dealings with Cyprus have gone one better. In the eurozone it is bank deposits that will now be considered by investors to be the risky asset. The Troika have managed to exponentially increase concerns on how safe retail deposits are in the eurozone. It matters not that the final Cypriot bailout plan did not touch smaller savers unlike the original proposal of a 6% tax (haircut) for ALL deposits under 100,000 in ALL banks (including foreign bank subsidiaries). The fact that this plan was originally sanctioned, despite deposit insurance, will have shaken small saver confidence to the bone. It certainly has shaken my confidence. I know from first-hand experience the extreme difficulty for a European citizen to open an account in another European country it is nigh on impossible for the man in the street. If Joe Sixpack in Spain or Italy or wherever is thinking the Troika are circling their country in the future, it is entirely rational, as Mervyn King suggests, to panic! (The Bank of England Governor, Mervyn King once said it was not rational to start a bank run but rational to participate in one once it has started.) But euro-Joe Sixpack is left with the choice of stuffing his money under the mattress or buying safe financial assets (maybe overseas mutual funds or gold?), or indeed spending the money on goods and services. The highly regarded commentator Gavyn Davies makes the point in the FT that although Cyprus is tiny enough to be completely overlooked in most circumstances, its economy and banking system have characteristics similar to other, much larger, eurozone countries. Cyprus is certainly at the extreme end, but an over-leveraged banking system, with insufficient capital and reliance on foreign funding, is familiar territory in the eurozone. Cyprus is therefore, in some respects, a microcosm of the entire eurozone crisis see left-hand chart below.
Private sector credit (av 2008-2010, % of GDP) Banking Assets (end 2011, % of GDP)

Source: World Bank

Source: Belgium Financial Sector Federation

Indeed I heard a very cogent defence of Cypruss position by Nobel prize-winning economist and my former economic lecturer, Christopher Pissarides, who heads Cypruss Economic Policy Council. His response to the criticism that the Cyprus economy was, like Iceland too dominated by banking was what about Luxembourg? Looking at the right-hand chart above, he may have a point! Part of the Troikas explanation for forcing depositors to take a haircut as part of the bailout was that not to do so would have seen Cypruss public sector debt/GDP ratio rocket up by 50%+. Indeed last summer all EMU leaders signed a pledge to break the vicious cycle between banks and state insolvency. But as the UKs Daily Telegraph correspondent, Ambrose Evans-Pritchard highlighted, this consensus was quickly broken as an alliance of hard-line creditors said the European Stability Mechanism (ESM) or bail-out fund could not be used to cover legacy assets from past banking crises. Ambrose goes as far as to use the word betrayal to describe these events (see link).

27 March 2013

Global Strategy Weekly

So instead of recapitalising Cypriot banks directly via the ESM, the Troika ultimately found another, more traditional way to deal with the Cypriot banking insolvency for that is what it is. And for someone like myself who cut their market teeth during the early 1990s US Savings and Loan and banking crisis, my own view is that what has happened in Cyprus should have happened to many other banks by now (especially in the UK). But the debate whether insolvent banks should be recapitalised by the taxpayer or liquidated, is undoubtedly a sensitive one. And who decides if a bank is insolvent or merely having liquidity problems? These issues are dealt without much fuss in the US. The Federal Deposit Insurance Corporation takes over failed US banks and wipes out creditors in order of seniority. Usually once equity and bond holders are liquidated there are enough assets to repay uninsured in addition to insured depositors (but not always). And if anyone looks at the list of banks taken into receivership (here) and says that these are small regional banks, scroll down and look at September 25 2008. In the immediate aftermath of the Lehmans bankruptcy Washington Mutual was seized after suffering a run amounting to almost 10% of deposits. At the time it was the 6th largest bank in the US and became the largest bank failure in American financial history. It was done smoothly and efficiently without cost to the taxpayer. What for so long has been normal in the US has clearly become the new normal in the eurozone. The Cyprus bailout has intensified anti-German sentiment around the periphery of Europe. This is, as Gideon Rachman points out in the FT yesterday, unfair. Yet a project specifically designed to avoid conflict within Europe has led to extreme hostility towards Berlin. Gideon believes this is partly because under President Franois Hollande, any notion that France is playing an equal role to Germany has disappeared. Over Cyprus, even the Finns seemed to weigh more heavily in the debate than the French. link. My final observation about the current eurozone conjuncture is to remind readers about the fate of the East German MZ motorcycle company (see picture below). Prior to the 1990 reunification of Germany these motorcycles were an extremely common sight (eyesore?) on the streets of London. But in what many saw as a cynical vote catching measure, Chancellor Kohl allowed the East German savings in Ostmark deposits to be converted into the Deutschmark at a one-for-one exchange rate (the black market rate was nearer to 10-1). The immediate euphoria of East Germans being able to spend their savings at a favourable exchange rate was replaced by gloom as East German industry was bankrupted at this wholly incorrect exchange rate. The quaint, oily MZ had a market at the right exchange rate. At the wrong one East German industry was bankrupted and West German citizens were forced to ultimately pay a heavy financial price for the resultant mass unemployment. And now all these years on one could say we are dealing with almost exactly the same issues: i.e. countries locked together at wholly inappropriate bilateral real exchange rates? Plus a change
The East German MZ TS250 was a frequent sight on the UK roads until German reunification

Source: www.realclassic.co.uk/mz04092700

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Global Strategy Weekly

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27 March 2013