Spain's "Sucess"

Big news this week was that the ESM had successfully ended the support towards Spanish banks, a story which came in addition to the already positive outlook for the country. In the words of the Spanish Finance Minister "2014 will see the net creation of jobs, higher even than we predicted in September in the budget, and the jobless rate will fall". The ESM has also provided us with a list of the positive developments in Spain which made it possible for it to exit:

1. Bank restructuring is well underway.

2. Transfer of impaired assets to an asset management company (SAREB, i.e. a "bad bank") has been completed.

3. Steady reduction of Eurosystem funding.

4. Positive banking results in 2013.

5. Markets acknowledging Spain's progress.

While these are all good news, there are still many problems which have been kept hidden under the carpet. First of all, we 'll start with the infamous unemployment rate, currently at the staggering 26.7%, meaning that more than one out of 4 people in Spain is unemployed. Add to that an astonishing 56.1% of youth unemployment and you get a much better picture of how things are doing in the country. Oh, wait there's more: 7.1% of the labour force in the second quarter of 2013 was just working part-time, brining the percentage of the people working full time is just 66.2% of the population.

What does high unemployment indicate*? Since people tend to consume out of income, it means less consumption. The trend has been obvious in Spain over the past years:

With less consumption, firms will be facing more trouble than before, with the trend of new orders and firm bankruptcies continuing:

Don't let the decrease in Q3 bankruptcies fool you: remember that the Spanish economy is highly seasonal (as are most of the periphery countries, especially those with a large inflow of tourists) and as restructuring specialists commented "2013 is going to be the year with the most bankruptcy filings in Spain's history, without any doubt".

All of the above have important consequences to the health of the banking system: overall Bad Loan ratio climbed to 12.7% in September 2013 compared to 12.1% in August, while the severe deleveraging of the banks' balance sheets continues as we speak. The ESM focuses on the positives, yet the problem is that they use just Q2 data, which allows them to focus on what they like. For example, in Q2 industrial production rose by 0.8%, making some very happy. Yet, the Q3 data show that the increase was not permanent:

One cannot be certain of how Spain will fare in 2014, yet the popular opinion (and the one shared by yours truly) is that the coming year will be better than 2013. This has also been shared by the market: with the danger for a Spanish or an Italian default reduced, bond yields have decreased over time. Yet, whether the over-optimistic estimations of the Spanish Finance Minister will occur is something which is really doubtful. For significant growth, we need stabilization and Spain has unfortunately not yet stabilized.

The fact that the ESM stopped its backing of the Spanish economy is rather irrelevant to the stabilization of her economy: the credit provided was just the amount needed for her banks to continue functioning and nothing more. The Spanish authorities have agreed to exiting the ESM based on the fact that the worse is over. We agree on that; but it doesn't mean that the situation will get better. If anything, optimists would expect the situation to stabilize over 2014, with some quarter-to-quarter growth after the stabilization as the austerity-based new budget, with more cuts in spending and more wage-freezing for public servants. The country's increased exports make it more prone to external shocks and the payments for the debt assumed in order to revive the banks will drive policy for some years to come.

So, ESM, let's be realistic: Spain is anything but stable. Don't focus on just the positives and please give out up-to-date data. 2014 will be good for stabilizing the economy and some slight growth if the increased austerity does not cause more harm in the end. Everything else is just wishful thinking.

*Some argue that unemployment fell in December 2013. The problem is that the hires were highly seasonal and in addition, the Spanish labour force appears to be shrinking as Euronews reports. Thus, the good news are nothing but the absence of bad ones

Why a Deposits Haircut is a Terrible Idea

One of the newest ideas that the great masterminds of the European bail-outs have come up with is the one where a deposit haircut takes place, in order for the Cypriot state to assume less debt in the bank re-structuring process. Although we have not yet seen what such a proposal actually promotes (since it has also never been implemented in any country in the world), it would be save to assume something of the following according to Reuters:

People with deposits over amount X in a bank (although it has not yet been defined whether this would include just banks which need restructuring or any bank at all) would take a loss in order to make the banking sector smaller; this loss is expected to be compensated by new share issues. Reuters puts number X to equal €100,000.

The amount at first appears significant enough; not everyone can brag for €100,000 cash in their accounts can they? Yet, a closer look shows otherwise. A person who saves just €110 a month, assuming a 3% nominal interest rate, will end up with more than €100,000 in the bank after 40 years. Would anyone call such a person rich or well-off? I do not think so. It is more likely that this person plans to send his children to the university or live his later years live more easily with that amount.

Then, we should consider the risk assumed by the deposit-holder. Cash are unanimously considered as zero risk financial assets both because they are guaranteed by governments and because the initial investment is never at risk. If such a scheme is applied then we are essentially transforming risk-free assets to risk-bearing ones. What is more, we are transforming them into the second riskiest asset class (the first one being derivatives) there exists: stocks. Why would a person, who does not want to assume any risk, be willing to put money in the bank then if they are safer under the mattress?

In fact, a deposit haircut appears to be even worse than most austerity measures. It is a purely un-democratic proposal which aims precisely at allowing innocent people assume responsibility for someone else's fault. Austerity measures are usually promoted with the aim of reducing state expenses and affect the current income of workers; the deposit haircut is promoted just to save financial institutions and it affects consumer wealth. If we know that a decrease in government spending leads to a reduction in consumption and an increased rate of non-performing loans how can we even believe that the results of decreasing wealth will not have even worse results in the real economy?

As already noted, this has never before been implemented in any part of the world. If Cyprus, who under the English Law allows bondholders to sue the state for any debt haircuts, tries to implement such a scheme, results are bound to be devastating. In a 2010 paper on repo haircuts the authors conclude that (emphasis my own):

"Increases in repo haircuts are withdrawals from securitized banks - that is, a bank run. When all investors act in the run and the haircuts become high enough, the securitized banking system cannot finance itself and is forced to sell assets, driving down asset prices. The assets become information-sensitive and liquidity dries up. As with the panics of the nineteenth and early twentieth centuries, the system is insolvent"

Their results can be easily understood in terms of trust. If I do not trust that the bank will take care of my money and that they will be there when I need them why should I keep my money there? Then, if this does not hold for me, why should it hold for everyone else? Thus, we all refrain from keeping our money in the bank and we move to withdraw them; bank runs occur. With the enormous drop in liquidity the general economy also takes a tumble. For those who do not believe that such bank runs are possible nowadays I would point that Cyprus lost €1.7 billion in deposits during January, when this scheme was just a rumour.

The time for utilizing ESM funds has arrived. Although Mario Draghi put the markets at ease in September by saying that the ECB will do everything it takes to keep the euro alive, very few will still believe his words if they are not put into practice. The EU officials should be thankful that the opportunity to test the ESM came with Cyprus and not with Italy or Spain. If something does not work in the Cypriot case then the amount of money lost will be minimal compared to what would happen if Spain or Italy were assisted and things did not turn out as planned.

Again, let us not forget: our economic system is based on trust. If we cannot continue to trust the system then it will simply collapse.

The Cypriot Patient

Good news for the Greeks yesterday, as the S&P ratings agency has upgraded the nation by six notches, from "Selective Default" to a "B-", with a stable outlook. Hopefully, the agency can understand the situation better than everyone else, and the Greeks will be able to say that they have put the worst behind them as 2013 leaves. Yet, their neighbouring Cyprus now appears to have taken a harder hit than first expected: the approximate bail-out package just for bank recapitalization is expected to be about €10 billion, the second largest in history, measured as a percentage to GDP.

Newspaper cover from Cyprus. Source: cyprusgasnews.com

Data for the second quarter of 2012 have shown that so far the island has a 74.6% debt-to-GDP ratio, or approximately €13.2 billion (simple calculations can show that Cyprus's GDP is about €17.7 billion). If we just add the €10 billion to receive the amount would reach a staggering 130% debt-to-GDP ratio, or €23.2 billion. Although I cannot find the article now, I remember a Cypriot authority stating that the debt burden would not exceed 120% (or at least that's what he hoped for), a threshold over which debt is not considered viable any more. It would appear that this was just wishful thinking.

The interest rate for the €10 billion bailout is expected to be around 2.5%, as Finance Minister Vassos Shiarly expects. Although I would like to know where he got those expectations from, even if he is right, an island whose budget is around €9.5 billion, would have to pay about €250 million per year just on interest payments.

Is this sustainable then? The answer is it will depend on how the Cypriot economy will react to the fiscal adjustments (aka austerity measures) the government in association with the Troika has pushed through. The expected adjustment will reach 7.25% of GDP. Assuming that GDP only declines by 3.5% as expected, it would mean that the debt-to-GDP ratio will increase by more than 5%. Oh, and the careful reader will also note that in the above calculations the amount paid for debt refinancing and other government needs has not been added. Guess how the calculation for sustainability goes when another €6 billion is added on the tap. Yes, exactly like Greece's.

What many have not yet realized is that although bad spending policies by the government and bad decisions from the banks have worsened the problem in Cyprus, another culprit has to be the Eurogroup itself. Had the infamous decision for cutting Greek debt by 70% not been taken, the Cypriot banks would not have lost around €4 billion of hard-earned money. Instead, they are now eager to receive government support or they will have to be liquidated. (for more details on who to blame for the crisis read this).

Obviously, one would be insane not to assign blame to the politicians or the bankers, who have tolerated and promoted a policy of over-spending and over-lending for years. An asset bubble had been raging for years in the island, assisted by the bankers, land developers and foreign demand. Now that the time for things to go back to normal has finally come, people naturally hate it. Living in fantasy for too long will cause you to forget what reality really is. It appears that everyone seems to forget that a correction was bound to happen some time. For Cyprus, this time is now. Nevertheless, consequences would have been much easier had the Eurogroup not taken that decision. Not just for Cyprus but for the rest of Europe as well.

Nevertheless, Cyprus can feel that it has been treated unfair for two reasons:
1. The aforementioned Eurogroup decision has brought the crisis much faster than the economy expected it.
2. The Cypriot banks are not getting funded by the ESFM/ESM funds like Spain's but are forcing the government to assume responsibility for them.

Even if we accept that Cyprus had opted for a bail-out before Spain did, it would still appear that the EU has a strange way of operating the ESM: not depending on the bank or its significance in the local economy, but on a sovereign level. If a nation is more important than another, economic-wise, then it would appear that they will support it and let the other fall. Yet, this is not the solidarity the EU officials have been proclaiming and surely not the preservation of peace and equality, values for which it received the Nobel price earlier this month.

This sort of injustice sets a paradigm for the EU authorities: they operate exactly like national governments do: assist people in power, those who are economically strong or have good connections and do not pay much attention to "ordinary" people. They just do it on a wider scale. Is this the kind of governance that we should be happy about, or is this how the first visionaries saw the EU becoming? I would certainly hope not.

As for the sustainability of the Cypriot debt, it looks that history will be repeating itself: Greece and now Cyprus. A €16 billion package will not be enough if the banks are not directly funded by the ESM/EFSF. New memorandum will have to be signed soon, and debt reliefs will be implemented.

That is, unless they bring their minds about and decide to do what would really make the island's transition from recession to recovery easier. Otherwise, it would be recession to depression.

A Good Day For Europe

At last, after months of discussions and speculation, the German Federal Constitutional Court has given the green light towards the creation of the European Stability Fund (ESM). This means that the Fund can give up to €500 billion of loans to Member-States in need. In addition to Draghi's announced bond-buying program, this is expected to bring a new era of calm in the markets. However, what is more important is that they are giving out the signal that both the EU and the common currency are here to stay.

In essence, this would mean that all rumors and speculation concerning the fall of the euro, the Union, a sovereign exit or bankruptcy are unfounded. Thus, after these are refuted, stability and calmness is expected to appear on the markets, in contrast to the panic which lasted for almost a year. Nevertheless, not to be forgotten is that individual nations are still struggling to survive
, and for some (Cyprus, Italy and Spain), the worst is yet to come.

Tomorrow, in Nicosia, Cyprus, the Greek Prime Minister, Antonis Samaras, is expected to announce the new austerity measures at the Eurozone finance ministers meeting. Although the flow of cash to Greece is not expected to halt as none of the decision-makers has ever stated such an interest, the Troikans will issue their next report in October where the Greek government is expected to come short of its targets. In the same meeting the situation in Spain is expected to be discussed. Even though a package of €100 billion has been made available