Don't Shoot the Messenger

Under Stress

After a long and rather tense wait, the initial response to the publication of the European bank stress tests was always going to be something of an anti-climax. Indeed the results should hardly have come as a surprise to anyone. It is hardly breaking news to learn that a number of Spanish cajas will find themselves badly undercapitalised if the economic recovery – as surely might be expected – fails to materialise as planned. For the rest, the outcome is really a victory for politically correct thinking. The situation, we learn, is slightly more serious than previously acknowledged, but we are a long way from seeing the imminent collapse of the European financial system. How could we be, when we have the friendly face of the ECB, always there ready to offer a helping hand. 

The problem with the tests, is what they tested, and what they didn’t. Obviously bank exposure to vulnerable sovereign debt is an important issue, but with that 750.000 million European Stability Fund waiting near the table, sovereign default by a Euro group member state is hardly a short term probability. Much more important in the Spanish case is the interest rate risk associated with the domestic mortgage book. That is to say, what happens if mainstream Europe does finally recover one day? Will the ECB implement its exit strategy even while the peripheral economies are left stranded, desperately seeking growth, but hardly able to find it. And if it doesn’t, won’t that simply mean that the whole Eurozone has become another Japan. And what will be the implications of this?

What will happen to the Spanish banking system if the ECB is able eventually to normalise interest rates (Let’s say to 4%)? What will be the impact on the ability (and willingness) to pay of those who find themselves in debt for a far larger sum than the value of the property that they originally got themselves into debt for? Remember, over 90% of householders with mortgages are on variable mortgages (normally linked to 1 year Euribor), and in the more recent vintages the loan to value ratios are often high, with the proportions of disposable income which need to be committed to mortgage payments also commensurately high. The answer to this most important of questions is we really don’t know because this issue isn’t given the importance it should be in the test procedure. Simply put, in the present case what you ask for really is what you get.

So the real issue facing the Eurozone is a long term and not a short term one. Can the coordination mechanisms which are currently being put in place survive a decade of extraordinarily low growth in the worst affected economies? Will the more economically dynamic parts of Europe be prepared to carry the rest in the same way that the richer regions of Spain give support to the poorer and less dynamic ones? Is the sense of European solidarity strong enough, or will we see a new resurgence of national interests? Certainly the signals that have been coming out of Germany in recent weeks are none to encouraging in this regard.

Nor are recent developments in the East of Europe, and in particular those emanating from Hungary any more reassuring. The Hungarian government have simply told the Europe’s leaders that they are not willing to implement more austerity programmes, since they have no electoral mandate for this. Effectively they are holding a gun to the European Commission’s head, in the full knowledge that no one can afford to see the Hungarian financial system plunged into crisis, for fear that this would produce contagion across the whole region.

The problem being highlighted in Hungary is what can happen to a country if, after three or four years of continuing sacrifice the population at large still see no signs of real improvement. Europe’s institutions and the IMF are always there to lend money, if more is needed, but in the longer run what many of the countries involved need is economic growth, exports, and current account surpluses, not yet more debt.

The present crisis is, as we are constantly being told, a global one. Sometimes it seems this argument is advanced more as an excuse, than as a recognition of the severity of the problems we all face. The sad truth of the matter is that at this point in time what most of Europe’s economies need is a strong surge in exports. But this surge is made doubly difficult given the generalised dimension of the problem. Having a global crisis simply means that the sacrifices needed to escape from it will be greater, and in true Darwinian fashion only the fittest will survive.

So, we might ask ourselves, are we all any less stressed now we have those long awaited results in our hands? In the short term the answer is obviously yes. The clear lesson is that Europe’s leaders will do whatever is necessary to save the banking system, and the ECB, having now bent to the Commission’s will (during that fateful May weekend) has the ammunition to do whatever it takes – expect “normalise” monetary policy. But, in the longer term the answer is obviously that it depends. The publication of the results will do little to change investor perception of the deep problems most of the Eurozone’s severely affected economies will have in carrying through the much needed structurally correction in the context of a monetary union which does not make devaluation possible. The only thing which will really return the kind of confidence which we all so badly need to see for the Spanish economy is a convincing and credible plan for restoring growth. And the real test will be the following – just how long is it likely to be before we will be able to talk of the “crisis” as something which is over and done with. As a part of our past and not part of our present. In this sense, the events of the last week have changed very little. We are all still far more stressed than we would like to be.

Originally published at Credit Writedowns and reproduced here with the author’s permission. 

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