Elections in Austria: Yuck.

Short version: for the last two years, Austria has been run by a “grand coalition” government of the two largest parties, the Social Democrats and the center-right People’s Party. Everybody hated this arrangement, though, and it didn’t get much done. So they called new elections, which were held yesterday.

Result: both large parties got hammered badly. The Social Democrats seem to have dropped from about 36% to 30%, and the People’s Party from 35% to 26%. (Ironically, it was the People’s Party that pulled the plug on the coalition last month.)

The big winners? Austria’s two creepy nationalist-populist-nativist-immigrant hating parties, the Freedom Party and the Alliance for the Future of Austria. The Freedom Party jumped from 11 to 18 percent of the vote, while the Alliance went from about 4 to 11. Together, they’re now about as big as either of the two traditional large parties.

At this point I should probably discuss how these two parties differ, and how one is more populist and the other more nationalist, and which is creepier, and all. But this would involve talking about Joerg Haider, which I just don’t feel like doing today. Sorry. Suffice it to say that they’re both fairly squicky, and the fact that nearly 30% of Austria’s electorate voted for them is just depressing. Yeah, yeah, economic anxiety populism anger at the ruling coalition blah blah blah. And it’s not that big an increase from the Freedom Party’s equally depressing showing in 1999, when they got about 27% of the vote. Nevertheless.

The Greens also squeaked in with their usual 9% or so.

Now, the Social Democrats have said they won’t go into coalition with either of these parties. So Austria’s crappy, ineffective grand coalition is about to be replaced by…

1) The same crappy, ineffective grand coalition, except with fewer votes and less legitimacy; or,

2) A coalition of the People’s Party and either both the obnoxious parties, or the Freedom Party and the Greens. This would be rather strange, if only because a party that’s been so firmly rejected doesn’t usually come back to form the next government. But then, the People’s Party was in coalition with the Freedom Party for several years after 1999. Some readers may remember that most EU nations refused to have any dealings with that government for, oh, six months or so. That worked out real well, not.

Either of these would kinda suck. (1) gives a weak coalition government that pretty much starts out discredited. (2) is 1999 all over again, with the rest of Europe squirming uncomfortably and avoiding eye contact while Haider and friends slap on another layer of pancake makeup — see, we’re legitimate and honorable nationalists! Also, whether it’s People’s Party/Freedom Party/Future or People’s/Freedom/Greens, this coalition would suffer from the fact that the two smaller members loathe each other — for personal reasons in the first case, ideological ones in the second.

At the moment it’s looking like (2) is the way to bet, but we’ll see.

Elections in Belarus: Um….

Belarus also held parliamentary “elections” this weekend.

Going into the elections, supporters of President Lukashenko and his government held all 110 seats in the country’s House of Representatives: there was no parliamentary opposition.

As of 9:00 this morning, it was clear that government supporters had won… all 110 seats in the House of Representatives. There will be, again, no parliamentary opposition.

Most of the news articles on this election have focused on how Lukashenko is trying to improve relations with the West, or how the opposition was divided, or how the OECD is going to pass judgment on the elections tomorrow (wonder what they’ll say?), or such. But — taking a step back and trying to look at the medium and long term? — what’s interesting is that Lukashenko is pre-emptively making it very, very difficult for Belarus to have a post-Lukashenko transition.

Broadly speaking, the post-authoritarian transitions of the last twenty years have gone best in those countries where there was some sort of formal and legitimized opposition. — That’s for broad values of “opposition”. Hungary in 1988 didn’t have much of a Parliamentary opposition in the Western sense, but it allowed a modest diversity of opinions and some open criticism of the government and its policies, and there could occasionally be debates whose outcomes were not pre-ordained by the government. This was in sharp contrast to, say, Romania or Albania, where the Parliaments were echo chambers and almost completely without agency.

Lukashenko is keeping himself firmly in power by — among other things — methodically eliminating plausible alternatives. If authoritarian rule were to collapse in Belarus tomorrow, there’d be no formal source of democratic legitimacy. Belarus’ Parliament is useless for any purpose but upholding a single strongman… and that’s a feature, not a bug.

A new Parliament could be elected, of course. But it would have to learn the habits and structures of representative democracy completely from scratch. Recent history shows this is harder than it looks.

Elections in Bavaria: Huh..

Bavaria also had elections this weekend. (I posted about the campaign last week.)

Surprise: the Christian Social Union, which has ruled Bavaria without a break since forever, lost big. For the first time since 1962, they won’t have enough seats in Parliament to rule alone; they’ll have to take on a partner, most likely the FDP.

The big winners were the small parties — the FDP, Free Voters, Left/Linke, and Greens. Die Linke dididn’t quite reach the 5% threshold for getting seats, but they put on an impressive show anyway, jumping from nothing to 4.3%… not bad for a bunch of ex-commies plus Oskar Lafontaine, running in a rich, conservative Catholic state.

So what does it mean?
Well, the early reports are spinning it as bad for Chancellor Merkel and the CDU, because the CDU will need the CSU next year in the general election. If the CSU does this badly in 2009, the CDU has no hope of winning a majority. (Not that they have much hope anyway, but still.)

But it’s not good news for the Socialists either: they lost vote share too. And they were at an all-time low in Bavaria to begin with. So, really, who the hell knows. This election may have made another “grand coalition” more likely, but it’s still really early to say.

(Although here’s an amusing bit of trivia: the CDU has said that it doesn’t want another grand coalition, but hasn’t formally ruled it out. The CSU, on the other hand, went on record a while back as saying that it absolutely wouldn’t accept one. Someone should ask if they’re reconsidering that…)

Also of interest: the Freie Wähler hitting an all-time high with 10.2% of the vote. The FW are, at a state level, the “none of the above” party. They have no party structure, and they barely have policies or a platform. They bill themselves as the “common sense” party, which in Bavaria means vaguely conservative, but really they’re who you vote for when you just can’t abide any of the others. They’re unlikely to enter the state government this time — it’ll probably be a CSU/FDP coalition — but they’ll be the second-largest piece of the opposition, and quite possibly the most important; unlike the Socialists, they have some credibility beyond their immediate base.

Watching with interest.

[Update: just spotted this very good diary over at Eurotrib. Check out the comments thread for interesting details.]

Competitive guarantees.

One of the diagnoses of why the Great Depression was so bad is that countries engaged in “competitive devaluation” — weakening their exchange rates to make exports cheaper, but when all try to do this, no one gains, and confidence runs out.  One wonders today if Ireland has created a new version of this risk with the dramatic government announcement that it is providing a public guarantee to all liabilities of banks with their HQs in the Republic of Ireland.  That means every debt that these banks have to anyone: to their depositors, interbank lenders, and bondholders. 

This sweeping guarantee far exceeds that of deposit insurance, and means that any wholesale lending to the Irish banks — the part of the banking system that is nearly stalled at the moment — is now secured by the Irish taxpayer.  But foreign banks operating in Ireland, including Ulster Bank (owned by RBS), Rabobank (Dutch), and Postbank (part owned by, er, Fortis) are not covered.  Any wholesale lender to these banks now has a strong incentive to switch to one of the six Irish HQ’d banks to get the guarantee. 

And it’s still not clear whether the liabilities of UK subsidiaries of Irish banks are also included in the scheme, which would put Alistair Darling in a severe pickle about whether to offer a similar guarantee.  When Darling offered a similar guarantee to Bradford & Bingley, it was only in conjunction with selling the deposit business and taking the rest of B&B into immediate public ownership to be wound down.

Now would the world be better or worse off if every country moved to similarly guarantee all liabilities of banks?  In the short-term, perhaps better off, since interbank lending could proceed on a more confident basis.  But the precedent would be atrocious.  Those liabilities are matched to assets, and the cost to the taxpayer of any payout would depend on loan quality.  Which ultimately means that a responsible government would have to engage in tight oversight of lending decisions.  Which is sort of like running a bank.  Isn’t this a business that governments were supposed to be getting out of?

It’s also bad timing for Charlie McCreevy and the European Commission, who will announce tomorrow their proposals for a more pan-EU system of banking regulation within the constraint of the primary of national regulators.  Ireland seems to have announced its new guarantee without any consultation with the UK or the Commission, the latter who still have to judge, inter alia, whether the system discriminates against non-Irish banks (on its face, it does).   There’s no direct connection between the banking crisis and Lisbon, but other finance ministers might see this as another example of Ireland’s go-it-alone approach to the functioning of the EU institutions.

A Moment of Blatant Self-Regard.

Five years, one month and one day ago, A Fistful of Euros went live with its first posts.

Thanks to David, for getting the ball rolling and keeping it rolling; thanks to Tobias for keeping the back end running and the front end looking good; thanks to all of the writers; thanks to the commenters, for keeping us on our toes; thanks to the advertisers for keeping this little venture self-financing; thanks to the politicians and other public types for giving us such rich material to work with; and thanks to the readers, hope that you keep coming back for more.

Russia’s Crisis Spreads Right Across The Domestic Credit Market.

Well the action in Russia this week has moved on slightly, and the damage has started to spread from pressure on the domestic stock market (accompanied by capital flight) to the real economy - via a very rapid tightening in credit conditions for Russian domestic users. We are also seeing a rapid slowdown in Russian manufacturing industry as internal demand slows while the inflation-driven decline in cost competitiveness continues to make imported products (where available) an attractive alternative to the home produced variant.

Emerging-market bonds have been generally falling this week as the U.S. Senate’s approval of a $700 billion bank rescue package did little to revive demand for riskier debt, and Russia has, unsurprisingly, been among the worst affected. The extra yield investors demand to own developing-nation bonds rather than U.S. Treasuries rose 8 basis points yestreday to 4.14 percentage points after widening 12 basis points on Wednesday, according to the JPMorgan Chase EMBI+ index. At the same time the MSCI Emerging Markets Index of stocks fell 0.3 percent to 783.79, its lowest point in four days. While such data readouts do not of course exclusively define the outlook for the Russian economy, they do give us a good indication of the context within which economic activity occurs, and they also give us a very clear measure of the current level of global risk sentiment whose influence, as we will see below, lies right at the heart of the immediate shock that is hitting Russian households and businesses.

Central Bank Reserves Actually Rise

One indication of the slightly different panorama to be found in Russia this week - and of the way in which the recent government intervention is moving the focal point of the crisis away from the equity markets and into the credit ones - is to be found in the little detail that the dollar value of Russia’s international reserves actually rose $3.4 billion last week, following consecutive declines during each of the three previous weeks, according to data released this week by Bank Rosii. The value of Russia’s Forex reserves increased to $562.8 billion in the week to Sept. 26, after decreasing $900 million to $559.4 billion in the previous week. A significant decline in the value of the dollar (which only represents about 47% of the reserves basket) seems to have been behind what is really a technical revaluation - given that the effect is produced by the rest of the currencies in the basket rising in value against the dollar. But there is no doubting the fact that the capital flight has - for the time being - lost momentum, even though the central bank felt forced to sell an estimated $4.9 billion from the reserves last week to support the ruble, and an estimated $20.6 billion over the last four weeks.

About 47 percent of Russia’s reserves are held in U.S. dollars, 42 percent in euros, 10 percent in pounds and 1 percent in yen, according to the most recent figures released by the central bank on June 30, 2007. The share of the reserves held in Swiss francs was reported as being “insignificant”.

Moody’s Dowgrades Russian Banks

But while the bloodletting on the foreign exchange side seems to have abated for the time being - PNB Paribas estmated that some $57 billion were taken out of the country between Aug. 8 and Sept. 19, BNP Paribas - the outlook for Russia’s banking system has deteriorated significantly after been downgraded to a “negative” rating by Moody’s Investors Services last week.

Slowing asset growth, higher inflation and a decline in equities may constitute as lethal cocktail which produce a sytematic deterioration in the undelying fundamental of Russian banks, is the conclusion many investors are drawing from Moody’s latest “Banking System Outlook for Russia” report. Moody’s main expressed concern was the way in which Russian banks hadn’t cut back their lending in response to the recent change in risk sentiment, thus increasing their risk profile. The “structural weaknesses” that surfaced this month in Russia’s banking system and the possible impact of the global credit squeeze may hurt the ability of banks to repay debt and attract financing, Moody’s said in the report. Both OAO Sberbank and VTB Group, Russia’s biggest banks, declined following the issuing of the Moody’s report. Indeed only this morning (Friday) VTB shares have fallen back one more time, after the bank announced it lost 9.31 billion rubles ($360 million) in September due to “negative market dynamics.” Nine-month net income for the bank (under Russian accounting standards) fell to 7.44 billion rubles from the 16.8 billion rubles in the first eight months of the year declared in August. The drop followed a “revaluation of the bank’s securities portfolio,” according to the accompanying statement.

And the other main credit rating agencies have not exactly been silent, with Fitch stating earlier this month that Russian real estate and construction companies are the most at risk as domestic and international banks curb lending, while Russia’s credit outlook was cut to “stable” from “positive” by Standard & Poor’s on Sept. 19. S&P’s made the point that the Russian authorities face growing pressure to spend the country’s oil generated reserve funds, undermining the country’s longer term credit strength. They did however maintain Russia’s rating of BBB+, the third- lowest investment grade ranking.

Lending Conditions Tighten

Of course the result of these downgrades (coming hard on the heels of the loss of confidence in the ability of the Russian institutional system to reform itself) wasn’t hard to anticipate or slow in coming, and Russia’s largest lender, the state-controlled, Sberbank reported on Wednesday that it was going to raise interest rates on retail loans due to the sharp rise in its own borrowing costs. This would seem to be the first major trickle-down from the global financial turmoil onto ordinary Russian citizens, who are already struggling to see the wood from the trees under the impact of double-digit inflation rates. The point about Russia’s 15% inflation rate isn’t simply the “Alice in Wonderland” quality it has given to Russia’s recent growth spurt, what we need to think about is the way in which it distorts all those fundamental day to day decisions which the economy’s principal actors (households, companies and the government) need to take. Thus, there is much more to think about in the Russian context than the evident fact that it is a “resource rich country”: long term structural distortions which go unattended are never good news.

And with 32 percent of the retail lending market, Sberbank’s move will have a rapid impact on millions of ordinary Russians - since interest rates on loans are set to rise by anything between 0.25-2.25 percentage points, depending on the type of loan, and the quality of the collateral offered as guarantee. And, of course, the other consumer banks are all set to follow Sberbank’s lead in adjusting their lending conditions.

Sberbank is reported to be in the process of securing a $1.2 billion loan which will be 40 basis points more expensive than its last syndicated loan - a $750 million credit taken out in December 2007, before the impact of the credit crunch was really felt. Sberbank has said it will start passing these extra costs on to new customers immediately, while loan agreements that have already been signed will remain unchanged.

Hardest hit will be rates on mortgage loans taken out in roubles, which will increase by 1.25-2.25 percentage points, while rates for mortgages in foreign currencies will go up between 0.75-1.75 percentage points. Thus interest charged on these loans will rise to between 12.75 and 15.5 percent, depending on the type of collateral and other factors. Interest on other consumer loans - such as cash loans or for consumer durables - will be up by an estimated 1 percentage point on average.

Property Market Starts To Crash

And the trickle-down on loans is rapidly becoming a torrent on the mortgages front. One of the first casualties here would seem to be Moscow’s decade-long building boom as the sharp rise in interest rates squeezes developers in what has suddenly become the world’s third most expensive property market - bettered only by Monaco and London, according to Global Property Guide.

The case of the Mirax Group - the Moscow-based company that’s building the Federation Tower, which will be Europe’s tallest skyscraper when completed - is typical, since Mirax have just had to cancel plans to develop 10 million square meters (108 million square feet) of commercial and residential space after they found that interest rates on some loans had risen to as high as 25 percent.

Higher borrowing costs already are hitting demand for apartments, and Moscow-based Real Estate Market Indicators report that prices may fall in the fourth quarter of 2008 and continue falling in 2009. If this happens it will be the first decline in Moscow property prices in 11 years, they say. The property consultants suggest the drop may reach as much as 30 percent for some types of apartments by the end of 2009. This assertion is very hard to judge, but does give some indication of the kind of decline we may see.

Prices for homes in Moscow have risen more than sixfold since 2003. In the first six months of 2008 they were up 25 percent, reaching a record average price of 136,404 rubles ($5,318) per square meter, according to data from Metrinfo.ru, a market research company. Since June prices have climbed another 13 percent.

And it isn’t just in Moscow that the credit crunch is tightening its grip, Russian developers are also cutting apartment prices in the regions as a decline in mortgage lending lowers demand for housing. According to Russia’s regional press, sales of new apartments in Rostov-on-Don are down 40 percent this month from August, while sales in St. Petersburg have fallen by half since the spring. Prices are said to have declined as much as 24 percent as a result.

And the investment analysts are hitting Russian real estate hard. JPMorgan advised investors, in a research note this week, to “steer clear” of Russian real-estate stocks since the Russian property sector is expected to be one of the “hardest hit” in a global recession, while Unicredit analysts state that “The current situation in Moscow partly resembles Japan’s real-estate crisis of the 1990s” - personally I think that this is altogether the wrong comparison, but it does give some idea of the seriousness of the situation.

Russia’s builders have also started to take a beating. Shares of Sistema-Hals, the property company owned by billionaire Vladimir Yevtushenkov, dropped 25 percent to 75 cents at one point in London trading on Wednesday, touching their lowest level since shares began trading in November 2006, while PIK, the Russian developer with the highest market cap, has lost 78 percent of its value since going ahead with an initial public offering in June 2007. OAO Open Investment, Russia’s second-largest publicly traded property company, has declined 52 percent this year. LSR Group, the Russian developer and building-materials maker controlled by billionaire Andrei Molchanov, has fallen 64 percent.

Oh, How Are The Mighty Fallen

“The Federation Tower, which is due to be completed by the company in 2010, will be 506 meters (1,660 feet) tall and will replace Commerzbank AG’s headquarters in Frankfurt as Europe’s tallest building”. And this, we may like to ask ourselves, will be a monument to what, exactly?

Russia’s Railways Delay Bond Issue

In another sign of the way in which the global credit strains are now biting, OAO Russian Railways, Russia’s state owned rail monopoly, has said it is going to “hold off” on selling $7 billion of 30-year bonds due to the turmoil in global financial markets. The company had planned to sell $600 million of Eurobonds by the end of 2008 to finance an upgrade in what is effectively the world’s longest rail network. ING Groep NV, Barclays Capital and Morgan Stanley, the financial advisers on the loan, recommended waiting to sell the Eurobonds after they saw investor interest waning while the cost of borrowing surged. The impression that all this creates is that the global wholesale money markets are now firmly, but politely, closing their doors in Russia’s face.

Back in July, Prime Minister Vladimir Putin was busying himself advocating a $525 billion overhaul of Russia’s railway system, lauding the rail network as “one of the foundations of Russia’s political, social, economic and cultural unity.” Now, wasn’t it Lenin who once said that Russian socialism was nationalisation plus electricity, well Vladimir Putin seems to be suggesting that the new Russian capitalism is lots of public money to support the price of Russian equities plus railways, or words to that effect.

In fact the sad reality is, after all those ambitious words have been spoken and forgotten, that the current credit crunch will probably lead OAO Russian railways to reduce spending both this year and next (and after that we’ll see), both delaying and reducing the scope of the principal projected projects. Of course, the Russian govenment could fund some of the activity itself from the National Wealth Fund, but wouldn’t that be just the kind of activity which S&P’s are warning about? At the present time Russian Railways claim to have sufficient funds to pay off their current debt and state that they won’t need to tap the state-run development bank VEB for refinancing. The rail operator does, however, have 128 billion rubles of loans and bonds outstanding, including 16 billion rubles worth due next year according to estimates, so the validity and realism of their recent statements looks like it is about to be tested.

Moody’s Investors Service rates Russian Railways A3, the fourth-lowest investment grade level, while Standard & Poor’s rates it one step lower at BBB+.

Russia’s Manufacturing Output Falls

Obviously the credit crunch and construction slowdown is bound to work its way through to Russia’s real economy one of these fine days (as we have already seen in places like Spain and the Baltics), and one early warning sign on this front could be considered to be the recent evolution in Russian industrial output. In fact Russian manufacturing shrank for a second month in September, and in so doing registered its first back-to-back contraction since November 1998, as companies cut jobs and growth in new orders slowed, according to the latest VTB Bank Europe Purchasing Managers Report. The PMI came in at a seasonally adjusted 49.8, compared with 49.4 in August. The August reading was the lowest figure in three and a half years, according to the bank statement. On such indexes a figure above 50 indicates growth while one below 50 indicates a contraction.

Russia’s economic growth is obviously slowing quite quickly - and evidently far more rapidly than the government anticipated - largely due to the impact of the global credit crunch, the downward movement in oil prices and investor reaction to Russia’s “go it alone” attitude in international disputes.

In the present environment inflation is likely to slow quite rapidly, and in September this easing in infaltion was noted in the prices that manufacturers pay and charge, as highlighted in the VTB report: “The rate of increase in prices charged by Russian manufacturers eased for the fifth straight month to its weakest’ since at least January 2003″.

Oil Output Down

And just to cap it all, Russia’s oil production also fell in September as companies struggled with costs and maturing fields, effectively bringing the world’s second-largest crude exporter closer to its first annual drop in output since 1998. Production fell to 9.83 million barrels of crude a day (40.2 million metric tons a month), 0.4 percent less than a year earlier, according to figures released by the Energy Ministry’s CDU-TEK unit.

So What Can We Expect?

Well, in broad outline I don’t think the outlook has changed that much from when I wrote my last analysis two weeks ago.

As I said at that point, Russia is hardly the Baltics, so we should not expect the economy to go into a complete nosedive. A lot depends on the view you take about the future of energy prices. While the global economy is now evidently set to slow considerably - in addition to the reduction in growth rates already seen so far this year -and especially in the aftermath of the most recent bout of financial turmoil. Cleary oil prices are set to drop even further - and this will only keep pushing Russian growth down - but at some point the market will find a floor, possibly in the region of $80 a barrel. More importantly when it comes to the future of oil prices, I would not be banking on some kind of long and deep global recession. Many of those developed economies who are significantly affected by the bursting of their construction booms (and the banking issues which have gone with it) will probably have weak domestic consumer demand for some time to come, but a solid core of emerging economies may well take off again quite rapidly as we move into 2009 -and especially if energy prices drop back, and the current near panic in the financial markets settles down (people do, after all, have to put their money somewhere). So the emergent (and numerous in population terms) emerging economies should give another strong shove to what may have become a rather listless global economy. As a knock on effect this should also serve to put some life back into export dependent economies like Germany and Japan (who by and large are not reeling under the impact of the construction bust, although their banks may have been lending to people who are).

So the bottom line here, I think, is be ready for a sharp slowdown in headline Russian GDP, but don’t expect to see any imminent meltdown in the Russian financial system, one way or another they have the wherewithall at this point to keep limping forward. Of course, in the longer term, well, you know……

Doha can wait.

Gordon Brown does a nice job of grabbing the headlines with Peter Mandelson’s return to the Cabinet as Business Secretary.  It’s hard to divine what this means for the European Commission.  Catherine Ashton will take his place as Trade Commissioner and there’s nothing in her background that indicates that she’s as ready as Mandy was to push the WTO negotiations to the point of irritating the EU’s agriculture-intensive states.  In any event, trade has slipped down the list of headlines with the global financial crisis and Mandy has a well-timed opinion piece in the Guardian that clearly crosses into Charlie McCreevy’s banking regulation turf, so it was likely drafted with one eye already on the next job.   In fact, the kind of protectionism that used to draw concern on trade issues has, at least in an intra-EU context, shifted to finance with banking guarantees and bailouts.  As much as anything, Mandelson probably saw better of waiting around another year to push through a trade deal that no one cares about right now.  But can he keep out of trouble in the new job?

Enlarging the tubes.

In my work inbox this morning, a message from TeleGeography. Their latest report on IP transit pricing is out. This bit struck me: 1,000Mbits of transit over Gigabit Ethernet in Bucharest now costs no more than it does in London - and only a couple of dollars more than in San Francisco. That’s incredible, and impressive. Talk about returning to Europe. Interestingly, the price is almost identical whether you’re in North America or Europe; but it’s higher by a factor of seven in Sao Paulo.

As Europe’s Banks Falter, Is There A Risk To The Eurozone?.

“We do not have a federal budget, so the idea that we could do the same as what is done on the other side of the Atlantic doesn’t fit with the political structure of Europe,”
Jean-Claude Trichet, commenting last week on the Eupean “summit” in Paris last Saturday

“If you concentrate on California or Florida, it is not at all like Massachusetts or Alaska……It is the same in our case and we have to make a judgment what is good for the full body of the 320 million people” in the euro area.”
Jean Claude Trichet in an interview with Ireland’s RTE radio last July, following the controversial decision to raise ECB interest rates to 4.25%

“Europe gives up on a joint rescue plan against the crisis,” since the EU “lacks the necessary institutions to respond as the United States has done”.
Spain’s El Pais yesterday (Sunday 5 October)

For Europe, this is more than just a banking crisis. Unlike in the US, it could develop into a monetary regime crisis. A systemic banking crisis is one of those few conceivable shocks with the potential to destroy Europe’s monetary union. The enthusiasm for creating a single currency was unfortunately never matched by an equal enthusiasm to provide the correspondingly effective institutions to handle financial crises. Most of the time, it does not matter. But it matters now. For that reason alone, the case for a European rescue plan is overwhelming.
Wolfgang Munchau, The Financial Times, Monday 6 October 2008

The euro experienced its biggest one-day drop against the yen in seven years this morning as the deepening credit crisis prompted European governments to pledge bailouts for troubled banks while stopping short of giving any concrete programme of coordinated action. The 15-nation currency declined to a 14-month low against the dollar - hitting $1.3598 at 8:52 a.m. in London - and to its weakest in two years versus the yen after European leaders meeting this weekend avoided announcing any plan that would be equivalent to the U.S.’s $700 billion bailout. And the reason for the euro’s fall is clear, the ability of the eurozone countries to apply a concerted startegy to address the problems in the banking and financial system has been called into question, and nowhere is the huge gap between the currency’s ambition and its political architecture so evident as it is in the above two quotes from Jean Claude Trichet. When push comes to shove, the US Treasury, as we have seen last week, does not concentrate on the needs of Florida or Massachusetts, but on those of the entire United States, and who, may we ask is in a position to concentrate at this point on the financing needs of the whole 15 member eurozone-area, since trying to manage economies which are one organic whole by splitting them analytically into monetary and fiscal entitites simply isn’t going to work, and it never was. Let me expain.

The current pressure on the euro is more the result of liquidity and solvency problems in the banking sector (and perceived institutional deficiencies when it comes to being able to address these) than it is a response to the growing weaknesses in the real economies eurozone real economies, which, as I have already recently argued here, probably mean that the zone as a whole has now entered the first recession in its short history.

When it comes to the liquidity and solvency issues, I do think we can already identify some clear trends, since we can see that in those European countries which had substantial housing booms - the UK, Ireland, Greece, Spain and Denmark - the bank exposure is to the drop in the value of the underlying assets (the houses, or the land, or the malls, or the office blocks) and to the defaults in payments (either by builders or by companies, or by homeowners) which have their origin in the impact of the mortgage seize-up on the real economy (rising unemployment, declining bonus payments, falling retail sales and industrial output, etc), whereas in non-housing boom countries (lead by Germany, Italy, Sweden and Austria) the exposure is to lending which was made to banks in the boom countries - first and foremost in the United States, but also in the UK and Ireland (see Germany’s Hypo and it’s Irish subsidiary Depfa) and, of course (and the largest slice of this is yet to come) in Eastern Europe (lead by banks in Sweden, Austria and Italy).

The other key thread is whether or not the institution in question lent against deposits, or depended on the wholesale money markets for funding. The banks - lead in this case by the Spanish armada - who were most dependent on external borrowing are now evidently those who have (or are about to have) the biggest problems as the worlds wholesale money markets remain firmly closed, with little possibility of them being permanently reopened until this crisis is over.

In theory, the 27-nation EU structure should offer a ready means of coordinating policy. But while the EU has unified laws on areas like trade and labour standards (and in the near future on immigration) more broad-reaching policy harmonisation (such as fiscal coordination) has long been resisted, and the recent sorry attempts to introduce a basic constitution provide clear evidence of the difficulties which lie ahead for any substantial moves in this direction. The EU has no institutional equivalent of the US Treasury, which is why all the initiatives which we have seen to date - for all the European “feel” about them - have been either ad hoc bi- or tri- lateral arrangements.

US National Bureau of Economic Research head Marty Feldstein has long been on record as pointing out that the greatest weakness in the eurosystem architecture from the start has been the absence of a common fiscal system, and the inability to correct the problems caused by deficits in one country by drawing on surpluses in another. When he first raised these issues Feldstein was undoubtedly thinking about the possibility of asymetric recessionary processes, and the need to coordinate fiscal stimulus - and I doubt was thinking about a problem of the severity of the one we now face - but in the longer run he has been proved right, this sort of problem was always going to arise at some point or another. As Jean Claude Trichet is now finding out, in macroeconomic management terms you simply cannot have your cake and eat it.

My basic point is a simple one: the European institutional structure with a centralized monetary policy but decentralized fiscal policies creates a very strong bias toward large chronic fiscal deficits and rising ratios of debt to GDP. An effective political agreement among the Eurozone countries is needed to prevent those deficits.

Without either discretionary monetary policy or an automatic cyclical adjustment of interest rates or of the exchange rate, a country can stimulate aggregate demand only by fiscal policy. While a fiscal policy can in principle take the form of a revenue neutral change in fiscal incentives – e.g., an investment tax credit offset by a temporary rise in the corporate income tax rate – the usual fiscal response to an economic downturn is a tax cut that increases the budget deficit. Moreover, deficitexpanding fiscal policy has greater potency with the interest rate and exchange rate essentially fixed than it would if the country had its own currency.

There is also a greater need in Europe than in the United States to use discretionary fiscal policy to respond to an economic downturn in a “local” area – i.e., in a European country or an American state. This reflects both fundamental labor market differences between Europe and the US and differences between the two fiscal systems. By fundamental labor market differences I mean the much greater geographic mobility and wage flexibility in the US than in Europe. A sharp decline in demand for the products of Massachusetts, my own state, some years ago led to a relative decline in the Massachusetts labor force (more out-migration and less in-migration) and to a decline in the relative wage of Massachusetts workers. The European labor force is much less mobile (because of differences in language and culture and a general reluctance to move even within countries) and wages are much less flexible.

The contrast between the centralized fiscal system in the United States and the decentralized fiscal system in Europe is also very important in this context. A decline of economic activity in a single US state automatically causes a substantial decline in the flow of taxes to Washington from residents and businesses in that state and an increase in transfer payments from Washington. The magnitude is roughly equal to 40 percent of the local decline in GDP. This net fiscal swing constitutes a significant external fiscal stimulus to the local economy. In contrast, with the decentralized European fiscal system, a fall of GDP in any country causes a contraction in tax revenue in that country but very little net transfer from outside. In short, the combination of a centralized monetary policy and a decentralized fiscal structure in Europe increases the need for and the effectiveness of countercyclical fiscal policy.
Marty Feldstein, The Euro And The Stability Pact

The issue really is that any economy is a single organic whole, and that monetary and fiscal policy really form part of one integral continuum. Basically both are concerned with demand management, monetary policy via the indirect route of trying to influence peoples saving and borrowing behaviour, and fiscal policy via the direct route of either injecting or withdrawing demand from an economy. Trying to manage one without the other simply ends up in incoherence at the end of the day, and it is just this policy incoherence that we are in danger of seeing now as the financial crisis (and the political credibility one which is liable to follow in its wake if people aren’t careful) takes hold. Basically economies like Spain and Ireland, where the real economies are now almost in free fall (Spain’s industrial output fell at the fastest rate of any among the 26 key global economies tracked on the JPMorgan global purchasing managers index in September) need a substantial injection of funds via the fiscal conduit to enable their governments to inject liquidity and demand into their systems without those governments seeing their accumulated debt to GDP ratio’s rising at rates which will set of alarm signals over at the credit ratings agencies. And they need this funding now, since - and without wanting to sound too dramatic - the situation is deteriorating rapidly, and by the day.

Unicredit Sinks Like A Stone

The shares of Italy’s second largest bank, UniCredit SpA, fell as much as 16 percent at one point in Milan trading this morning, hitting 2.59 euros and taking the shares back into the region of the 11-year low of 2.55 euros registered on Sept. 30. The drop follows a capital boost of 6.6 billion euros decided on at an emergency board meeting held yesterday afternoon, where among the exceptional measures decided on to raise the cash was the idea of paying this years dividends to shareholders by giving them more company shares.

The “shares for dividends decision” forms part of a battery of measures which includes significant cost cuts and asset sales in order to try to guarantee that the core Tier I capital ratio, a measure of the banks’ financial strength, rises to 6.7 percent by the end of the year, from 5.7 percent now. A core Tier I of 6 percent or higher is generally considered an adequate minimum for banks, while anything below it starts to raise eyebrows.

During a chaotic day trading in Unicredit shares was suspended several times following the initial dramatic fall, and they were finally down on the day by 5.5 percent, closing at 2.914 euros. Indeed the problems being experienced at Unicredit lead the whole Italian banking sector down, and with it Italy’s S&P/MIB Index, which declined the most in more than seven years this morning, losing 1,435, or 5.5 percent, to 24,476.

But what if this had been a bank with a name of a large European country, or an acronym that refers to a large European city, banks that are simultaneously too big to fail and too big to save? I shudder to think what would happen when Silvio Berlusconi, Angela Merkel, Lech Kaczynski and the next Austrian leader have to meet to discuss the future of a large cross-border European bank.
Wolfgang Munchau, The Financial Times, Monday 6 October 2008

UniCredit SpA, is, as I say, Italy’s second biggest bank and it is also owner of Germany’s HVB Group. The current crisis started last week when shares fell more than 24 percent in three days as it became increasingly clear that the bank was going to need to raise money to strengthen its finances. One of the issues arising was whether or not UniCredit would be asked to help in the bailout of Germany’s Hypo Real Estate Holding, a development which could have negative consequences for Unicredit’s capital position. Hypo Real Estate was in fact spun off from the Unicredit owned HVB Group in 2003.

But Unicredit is also exposed due to the extent of its lending in Eastern Europe - which is estimated to amount to one quarter of the banks total lending operations. Unicredit is deeply involved right across Eastern Europe via its ownership ofthe HVB group, as well as via it’s ownership of Bank Austria Creditanstalt. Among other issues Unicredit is evidently exposed in the Baltics, given the fact that as of September 1, 2007 ASUniCredit Bank Estonian took over the business of HVB Bank Tallinn. But the extent of Unicredit East European lending is much more extensive than this, and with property markets in one EU10 country after another now likely to “correct” the problem is about to become considerably larger than simply the German Hypo Real Estate one. Unicredit made direct acquisitions in 2007 in Kazakhstan and Ukraine, while extending its position in the Russian banking sector. The first of these counries had a financial “sudden stop” in September 2007, while the latter two are in the process of a major domestic credit “unravelling.

Fitch Ratings last Thursday downgraded the Outlook on UniCredit to Negative from Positive. At the same time Fitch changed the Outlook on Unicredit’s main subsidiaries - Germany-based Bayerische Hypo- und Vereinsbank AG (HVB) and Austria-based Bank Austria Creditanstalt AG - to Negative from Positive. Fitch stressed as reasons for the downgrade the poor macroeconomic outlook in Italy and Germany and in particular the less benign outlook for some central and eastern European markets. Fitch also regards UC’s current capitalisation (end-H108 Basel 1 core Tier 1 ratio of 5.55%) as tight in relation to its risks especially given thatconditions in the wholesale funding market remain “extremely challenging”.

So the question is going to be, is Unicredit too big to fail, or too big to save?

Government Guarantees For Deposits

One popular way of handling the present wave of pressure hitting the banks has been to give guarantees to depositors. The Irish were the first to do this, and they have been subsequently followed by The Greeks, the Danes, the Swedes and now the Germans. Up to this point the Italian and Spanish authorities have been notably silent on the matter, and the reason why is not hard to imagine.

Basically Ireland may have quite large problems, but it can, being a small country, “piggy back” from the United Kingdom, by attracting deposits from their larger neighbour. An analysis carried out at Credit Suisse has shown how movements of cash by relatively few depositors may have a bigger effect in countries which a significant proportion of deposits is concentrated among relatively small percentage of the customer base, as is the case in the U.K. (for example) where 4 percent of the banks’ customers hold 45 percent of the deposit base.

But where can the Spanish banks look for this kind of support? It is their very size and the size of the problem they have that makes for the difficulty. The vaguely-insinuated plan which was “nearly - but never actually - proposed” at last Saturday’s Paris meeting was for a fund of 300 billion euros. But Germany’s Die Welt reported over the weekend that Hypo Real Estate alone will need 20 billion euros by the end of next week and 50 billion euros by the end of the year, to be followed by as much as 100 billion euros by the end of 2009. And this is just one relatively minor “quasi bank”.

Spain’s needs are likely to be much larger - I personally have estimated a sum of between 300 and 500 billion euros for Spain alone, between the need to roll-over toxic financial instruments and non-performing loans from builders and other corporates. And what about Unicredit? We have no real idea at this point how much funding Unicredit may need.

And so we need to go back to Marty Feldstein, and to think about the budget deficits issue. In general European governments have little room for large scale fiscal support either on the annual deficit side, or on the debt to GDP ratio one. Given the ageing-related commitments (pensions, health costs) which are looming (in particular after 2012) for some key European governments (especially Germany and Italy) it is reasonably clear that - following the deficits which were all too often being run during the “good years” - there is now not much headroom to play around with, and remember all this government support for banks that is bbeing freely undertaken has to be funded somehow - either out of revenue, or by raising debt. In particular, if certain of the EU national governments move back on the commitment to balance the budgets by 2011 then we will only start to shift from banking instition downgrades to sovereign rating ones. This is why I titled this post the way I did. If either Italian government finances, or the Spanish banking system, are simply allowed to unwind for lack of visible support, then the integrity of the Eurozone itself which most definitely be put at risk. And events could happen very rapidly indeed if either important systemic banks or a large sovereign government suddenly go into financial meltdown. So the visible lack of any coherent startegy or plan could not be reasonably considered one of those cases where some people somewhere busy fiddling with their thumbs while Rome and Madrid were burning, now could it?

You too can vote.

in the American Presidential election!

Well, sort of.

Those 16 votes? Georgia, because McCain has been rather more truculent towards the Russians. Some say there’s not much difference between the candidates, but apparently the Georgians disagree! Macedonia, because Obama has supported a resolution taking Greece’s side in the Great Name Debate. That hasn’t attracted much attention in the US, but it certainly has in Macedonia. (Why? Remember, Obama is from Chicago. Large Greek-American population. Macedonians, not so many.)

Otherwise, it’s… pretty consistent. Wonder why?