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EA Spreads: Why Should the Trend Change?

By Rebecca Wilder 

EA Spreads: Why Should the Trend Change?

They changed the title; but originally the NY Times reported “Euro Zone Agrees to Reinforce Maastricht Rules“.  That’s exactly what EA policy makers agreed to last week – not much to bring home.

The real shift in policy came from the ECB. Ambrose Evans-Pritchard highlights the ECB’s actions as ensuring some sort of bank profitability, while at the same time defining the buyer of EA sovereign bonds. The banks will access funding from the ECB for up to 3 years at a very low and variable rate – currently the policy rate is 1% – and earn a higher return on their holdings of government debt (This morning, Italian 2-yr debt is trading at 6.05% – not bad). The banks will be ‘encouraged’ to buy government debt, thereby ensuring a funding source for the sovereigns. But this is not a business model, neither for the banks nor for the sovereigns.

Europe is headed toward recession – in fact, it’s probably already contracting – and EU policy makers agreed to explicitly enforce contractionary policy. Kevin O’Rourke calls it a Summit of Death, while Paul Krugman argues the impossibility of the grand internal devaluation experiment. I call it economic oppression coupled with zombie bank deleveraging – it is absolutely not in Spain’s best interest to be pushing sharp fiscal contraction while the private sector is itself deleveraging.

But alas, they’ve decided to put off the only credible solution, fiscal union, for another time. I suspect that global investors are going to see right through this simple fact. External investors will grow tired of the zombie deleveraging and recession, of which more selling will cheapen bonds further. Regarding bond spreads, why should this Summit lead to any different outcome than the ones before it? It shouldn’t.

Until EA policy makers make a concerted step toward fiscal union, the bond crisis will continue to evolve just as it has at each crossroad in the past. The european sovereign crisis will deteriorate further.

The chart above illustrates the average 10yr spread of the 9 bond markets listed over a like German bund alongside each major announcement date (see table below) through December 9. The trend has been up while volatile. Furthermore, no announcement to date has successfully stemmed the upward bias in bond spreads. EA policy makers consistently avoid the only truly credible answer: fiscal union.

Appendix

The table below lists the dates and associated ECB/EU announcements used in the chart above.

http://www.economonitor.com/rebeccawilder/2011/12/12/ea-spreads-why-should-the-trend-change/?utm_source=rss&utm_medium=rss&utm_campaign=ea-spreads-why-should-the-trend-change

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Krugman, Roubini, and the Eurozone

Krugman highlights but provides no link to Nouriel Roubini’s address to the 2006 Davos meeting (direct link to Economonitors here).

What I would say is that this incident exemplified something that was going on all along the march to the eurodebacle. Serious discussion of the risks and possible downsides was simply not allowed. If you were an independent economist expressing even mild concerns about the project, you were labeled an enemy and shut out of the discussion.

and in the same op ed It’s Not About Welfare States (via truthout) reviews election rhetoric and disinformation on the economic crisis in Europe being mainly welfare oriented countries:

Whenever a disaster happens, people rush to claim it as vindication for whatever they believed before. And so it is with the euro.

As an aside, the interesting thing about the introduction of the euro from a political point of view is the way it cut across the ideological spectrum. It was hailed by the Wall Street Journal crowd, who saw it as a sort of milestone on the way back to gold, and by many on the British left, who saw it as a way to create an alliance of social democracies. It was criticized by Thatcherites, who wanted to be free to move Britain in an American direction, and by American liberals, who believed in the importance of discretionary monetary and fiscal policy.

But now that the thing is in trouble, people on the right are spinning this as a demonstration that … strong welfare states can’t work.

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EA BoP Guide: CA and KA – EA too Dependent on Portfolio Inflows?

by Rebecca Wilder

EA BoP Guide: CA and KA – EA too Dependent on Portfolio Inflows?

This is part two of my multi-post commentary on the Euro area Balance of Payments (BoP). Yesterday, in part one, I compared the EA current account balance to its country-level cross section. Today’s post will be more instructive in nature, as I dig into the components of the EA current account (CA) and capital account (KA) balances.

My general conclusion is that the EA is highly dependent on foreign demand for EA assets in the identity of its international accounts.

As a note: remember the standard international finance identity: CA + KA + errors and omissions = 0, where CA + KA is generally referred to as the Balance of Payments. An international guide to the BoP can be found at the IMF website . Generally, the EA BoP statistics adhere to the IMF definitions.

The Current Account

The chart below illustrates the 3-month accumulated current account balance as the sum of its components: the goods balance (exports minus imports of goods), the service balance (exports minus imports of services), net foreign income, and unilateral transfers. The goods, services, and income balance is € 16.2 for the three months ending in September, which is more than offset by the unilateral transfer balance, -€ 28.1 billion.

The transfer debits are generally to and from other EU institutions and other non-EU and non G7 countries (see section 7.3, table 9), which reflects subsidies from the EA to EU budgets, remittance payments, and aid to developing economies. Given the stability in these outflows, this should be no cause for concern at this time. Of note, the goods balance shrunk spanning 2003 to current, while the service balance improved. In Q3 2011, the goods balance was just €1 billion, while the services balance was €15.

The trade and income balances balances generally fund the transfer outflows. However, recently the transfer balance has picked up (-€28.1 bn in the three months ending in September, which is up from -€19 or -€20 bn in the same month of 2004 and 2005). Given the dropoff in the trade and income balance, something is funding these unilateral outflows: the capital account.

The Capital Account

The chart below illustrates the 3-month accumulated capital account balance as a sum of its components: net portfolio flows (Port Inv – Bal, generally financial assets), foreign direct investment (FDI, or stickier capital flows), financial derivatives, ‘other investments’, and official reserves (ECB asset accumulation).

Since the crisis started, there’s been an stark inflow of foreign money (positive green bars) into the Euro area. It’s probably worth looking at this alongside the US TIC data to gauge interest in USD denominated assets for a proxy of global portfolio diversification – another post – I digress. The EA foreign direct investment is, and has generally been, negative. Foreign direct investment is long-term investment in other countries, including the retention of earnings for investment, equity investment, or long and short term loans. Most of the FDI is leaving the EA for the UK, ‘other EU countries (those not UK, Sweden, or Denmark, and “other countries” (likely EM countries in Asia and Latin America). You can see this information in section 7.3, Table 9. Official reserve asset accumulation is generally very small – one can barely see it in this illustration – and picks up in times of stress (like in 2008).

One interesting aspect of this data has been the persistently negative flows in ‘other investments’. Section 7.3, Tables 5-6 indicate this is driven by outflows in the banking sector (MFI’s). I’ll attend to this in another post; but there’s been a steady reduction to EA MFI’s via short-term loans.

The important feature of recent developments in the capital account is the sharp dropoff of the portfolio balance in September, just €31.5 bn over the last three months from €104.5 bn in the three months through August. This could be a one-off event; but the reduced foreign demand for EA assets could be problematic if a trend forms.

I would say that the EA BoP is not the most stable of all international flows. It’s now heavily dependent on portfolio flows – the green bars in the chart above – given the persistently negative foreign direct investment flows. Better put: the EA current account deficit is now funding through international asset flows into debt, equity, and lending markets. Given the deterioration of the sovereign debt crisis, I wouldn’t be surprised if these flows slowed further in coming months/quarters without a broad policy response from within Europe. Given the persistence of the transfer outflows, waning foreign demand for EA assets would pressure the currency downward if trade remains sluggish.

originally published at The Wilder View…Economonitors

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EA Balance of Payments: the Current Account

by Rebecca Wilder

EA Balance of Payments: the Current Account

I’ve been doing quite a bit of research on the balance of payments flows within the Euro Area (EA). Given the complexity of the balance of payments, there are too many angles to tackle in one post. Therefore, spanning the next week I will dedicate my commentary to the EA balance of payments. In this post, we start with square one: the current account.

The Euro area (EA) current account

Often times I hear comparison of the EA sovereign debt crisis to past emerging market balance of payments crises. This is not correct, since the EA runs only mild current account deficits, -0.9% of total EA GDP as of Q2 2011 (Q3 data reported in December). There’s no need for a sharp revaluation of the euro to drive the balance of payments to its identity – remember, the current account (CA) + capital account (KA) + official reserves + errors/ommissions = 0.

The standard emerging market-style balance of payments crisis goes something like this: large current account deficits must be financed by foreign inflows of capital (financial account surpluses), so that the currency comes under pressure when foreigners lose confidence in said emerging market economy. As foreign capital flows start to reverse, the currency comes under pressure to balance the financial and current accounts. Under currency depreciation, relative costs rise (via imported goods), so the central bank ‘defends’ the level of the currency through FX intervention (they sell down FX reserves and buy the domestic currency). With the central bank’s stock of FX reserves depleting quickly, speculators can sell the domestic currency for much longer than the national central bank can buy up those assets. Eventually, the whole thing comes crashing down. The currency depreciates (quite materially in some cases) and brings the current account into balance.

The EA initial condition for a balance of payments crisis is just not there: the current account is, well, rather ‘balanced’. Within the EA, country-level current accounts are well out of balance. This is the central theme associated with the EA sovereign debt crisis: debtor countries are reliant on foreign inflows of capital from the credit countries to support current spending.


The chart above illustrates the 4-quarter moving average current account deficit (red)/surplus (green) as a % of national GDP ending in Q2 2011.

In the context of the standard balance of payments crisis, Greece and Portugal would/should have seen precipitous nominal FX depreciation by now. In contrast, the Netherlands or Germany would have seen significant appreciation. However, the single currency union prevents nominal depreciation, so the focus has been on real depreciation. The debtor countries are forced into a policy of internal devaluation (fiscal austerity, they call it) to shift relative prices and real exchange rates. This could work if global growth was going gangbusters, but it’s not.

These imbalances are no longer sustainable.

I’ll leave you with a link as to the direction we’ll be headed here on The Wilder View. Last month Thomas Mayer released a report titled Euroland’s hidden balance-of-payments crisis, which describes imbalances building in the EA financial flows. Next post we’ll look into the balance of payments flows within the EA.

originally published at The Wilder View…Economonitors

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European Policy Makers Don’t Understand But Markets Do

By Rebecca Wilder

European Policy Makers Don’t Understand But Markets Do

So here we are: the Italian yield curve is flat at above 7%; the government institution is in question; and the ECB is using its SMP purchase program as a carrot to drive austerity implementation in and Berlusconi out. Some would argue that the ‘market is irrational’ – Italy faces a liquidity not solvency crisis. That’s the IMF’s line, and I don’t buy it.

See Italy’s situation is simple: given the Italian debt profile and initial conditions, the Italian sovereign should be able to stabilize its debt levels – even at 8% interest rate (borrowing costs) – PROVIDED (1) it grows, and (2) the sovereign increases its primary surplus (Italy is 1 of just 2 G7 countries expected to run a primary surplus in 2011, according to the IMF). The problem is, that (1) Italy’s contracting, and (2) a higher primary surplus is more likely than not going to aggravate the recession. Something has to change to break the link – this is where I encourage you to read Nouriel Roubini’s latest.

In my view, the market is behaving very rationally. The Troika (ECB+EU+IMF) adapted the standard IMF model to the European sovereign debt crisis as a means to regain market confidence amid a sovereign liquidity crisis. The plan is to enhance fiscal discipline and become more ‘competitive’ (usually that means coincident with currency devaluation).

So fiscal discipline + new competitiveness = market confidence. Right? Wrong.

Italy’s solvency is now under question amid current IMF-style bureaucratic policy in Europe. Why they haven’t figured out the following is beyond me: austerity and competitiveness gains only works if monetary policy is easy and/or the global economy is expanding, and that’s with nominal devaluation.

Either the IMF model will fail or the Euro area will

Here’s the problem with the IMF model:

1. None of the program countries are unequivocally more competitive. Devaluation would help here, but no Euro area (EA) economy can devalue unless they exit the EA.

The table below illustrates the gains in competitiveness by key EA markets since the beginning of the peak of the last cycle, Q1 2008. Competitiveness here is broadly measured by shifts in the real exchange rate, as calculated by relative prices, relative unit labor costs, and relative GDP deflators. The red cells highlight country real exchange rate gains/losses that undercut Germany.

Broadly speaking, no country except Ireland trumps Germany in two out of three measures of real depreciation. At best, the results on which country has indeed gained competitiveness against the 6th most competitive country in the world, Germany, is mixed. Furthermore, Europe as a whole is cutting labor costs, not just the program countries, and dragging domestic demand of the EA as a whole.

Ireland is the only country to have experienced broad depreciation across all three measures and against Germany. But I would argue this: they had further to go. The chart below illustrates the CPI-based real effective exchange rate. Spanning the period January 2007 to April 2008 (the peak), the Irish real exchange rate appreciated 10% against its major trading partners. As such, the 13.6% real depreciation since April 2008 is more reflective of mean reversion rather than competitiveness gains.

2. The second part of any IMF program (first, really) is controlling fiscal balances through ‘austerity’; but this is not possible if the private sector is simultaneously deleveraging and external demand is not sufficient. Spain and Ireland seem to be on track at this point – but they won’t be for long. The inevitable EA recession will increase the required ‘cuts’ to facilitate the reduced revenues; this is both logistically and nationalistically difficult. Global monetary easing is likely to help, but it’s too late for Europe.

Eventually the population will appeal to the economic malaise that is the disintegrating labor markets in program countries and fight against reform.

The divergence in economic performance is quickly turning into convergence, as the sovereign debt crisis inflicts the core economic performance. Shoot, even the ECB has acquiesced and is now calling for a ‘mild recession’.

Markets understand what policy makers in Europe do not: the European IMF-style model is not and cannot work under these conditions. Monetary policy is too tight, the global rebound has dissipated, and fiscal austerity is killing aggregate demand.

And here I get to my favorite quote of the day. From Bank of America’s Athanasios Vamvakidis (no link), a former IMF economist:

“In our view, there are two ways for a country to bolster market confidence in its economic policy: either through the intervention and support of an international institution, or through effective commitment to reform.”

Italy doesn’t need foreign capital, nor does it need effective commitment to reform. It needs a credible path of adjustment. And this involves all EA members, not just Italy. See Martin Wolf’s FT article from October 5, and Nouriel Roubini’s article today on EconoMonitor.

originally published at The Wilder View…Economonitors

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The Euro Area Precedent for Policy Failure

by Rebecca Wilder

The Euro Area Precedent for Policy Failure

Last weekend, a leaked Troika report (Troika = ECB + EC + IMF) revealed that European policy makers now comprehend that the Greek policy prescription is not working (bold by yours truly):

The growth and fiscal policy adjustments assumed under the program individually have precedent in other countries’ experience, but experience to date under the program suggests that Greece will not be able to set a new precedent by realizing at the same time and from very weak initial conditions a large internal devaluation, fiscal adjustment, and privatization program.

Rob Parenteau and Marshall Auerback sum up the implications of this point (1 A.):

On the first page of the document is not only a pretty open and blatant admission that expansionary fiscal consolidation (EFC) has proven to be a contradiction in terms, at least in Greece, but there is also a serious policy incompatibility problem, at least over the intermediate term horizon, with efforts at internal devaluation (ID) – that is, attempting nominal domestic private income deflation in order to improve trade prospects when one has a fixed exchange rate constraint.

I agree with Rob and Marshall – the grand plan does not work. Greece will (of course) not be able to set a new precedent of public sector and private sector deleveraging amid weakening external demand and a fixed exchange rate. However, I’d like to focus here on the ‘precedent in other countries’ experience’. What precedent?

One might point to Canada’s mid-1990s budget initiative that dropped program spending from 16.8% of GDP in 1993-1994 to 12.1% in 1999-2000 as a candidate for precedent. Marshall Auerback and Stephen Gordon refuted this claim as applicable to current conditions. However, we now have economic data available with which to compare the Canadian austerity experience to that of the Euro area.

What’s happened in Europe over the last year: Divergence. Since the middle of 2010, fiscal austerity and a drive for internal devaluation to ‘increase competitiveness (whatever that is) slashed GDP growth on a quarterly basis for all countries under the European Financial Stability Facility (EFSF) program – Greece, Ireland, and Portugal – while nonprogram countries enjoyed the economic benefits associated with a robust global recovery (through 2010). Note: fiscal austerity and ‘reform’ are pre-conditions to accessing funding at the EFSF. Not coincidentally, since Q1 2010, no Euro area countries have contracted except program countries (rounding to the nearest tenth) through Q2 2011.

The chart above illustrates the major Euro area (EA) economic (EA 12 less Luxembourg) recoveries since the peak in EA real GDP, Q1 2008. The legend lists the latest Q2 2011 reading as an index to the Q1 2008 EA peak – the difference over 100 represents the accumulated growth in real GDP. Only Belgium, Austria, and Germany retraced, or fully recovered, the lost EA real GDP. EA economic activity is 2% below pre-recession levels. Notably, Ireland, Greece, and Portugal are struggling amid tight financial conditions and the crimping of domestic demand (internal devaluation).

Since austerity and raising the primary balance is a  condition for EFSF funding access, a contracting economy is to be expected, right?

Wrong – in fact, the Canadian economy experienced no real GDP contraction spanning the years 1994-2000 when the structural fiscal balance turned from a 6.9% deficit to a 1.5% surplus. All the while, GDP maintained a 4% average annual growth rate and did not contract on a quarterly basis (after revisions). Admittedly, the Canadian economy did not grow in Q2 1995 and Q3 1995, but improved smartly thereafter.

I point you again to Marshall Auerback and Stephen Gordon for the whys. But basically, easy monetary policy, depreciation of the currency, and robust US demand fostered the fiscal shift in Canada. None of these conditions exist in the Euro area, so those program (austerity) countries – Ireland, Greece, and Portugal – suffer contraction.

As an aside, some may point to Ireland as a success story, since it posted two consecutive quarters of reasonably strong growth in the first half of 2011. Sure, Ireland eventually grew – it is a very open economy, so has an innate ability to generate net export income. But importantly, look how far the economy fell (see first chart). The economy saw 10.7% in accumulated contraction spanning Q1 2008 to Q4 2010 – the 3.5% rebound spanning the first half of 2011 pales in magnitude. I point you to Edward Hugh’s commentary for a sobering read on Ireland.

Finally, I leave you with a potent illustration of what not to do when it comes to fiscal austerity: Portugal vs. France.

Portugal was doing all right – better than France, even – until they ran into 2010 financial stability problems that forced the government to start ‘cutting’. Portugal started to contract in Q4 2010, applied for funding in April 2011, and contracted thereafter. Economic Intelligence Unit sees Portugal contracting throughout 2012 (no link). The Euro area prescription for austerity is tantamount to economic collapse amid a fixed exchange rate and meager global growth prospects.

The EA policy plan for fiscal austerity is setting a precedent, all right, a precedent for policy failure.

Originally published atThe Wilder View…Economonitors

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Don’t Hold Out for a Lasting German Economic Rebound

by Rebecca Wilder

German industry is plugging away. Ending in August, the 3-month average of the seasonally- and calendar-day adjusted volume of industrial production (excluding construction) maintained a quick 8.3% annualized pace. Even if this core measure of industrial activity falls another 1% in September, the Q3 quarterly annualized pace would be 10.5% – a robust acceleration from Q2 (6.3%). This suggests that the German economy quickened in Q3 – does that mean it’s all clear for the Euro area?

I think not.

According to The Wilder View Leading Economic Indicator (TWV-LEI), the annual pace of German manufacturing is set to slow quickly, if not contract, by the end of this year. (I constructed my own indicator since the OECD indicators are generally lagged by two months.) In September, five of the seven components that drive the index confirm a sharp deterioration in economic activity (the final two indicators have not been released yet). This downward trend in TWV-LEI for Germany has been in play since August 2010 and is yet to be fully reflected in industrial production (IP); that will change.

The chart above illustrates The Wilder View’s leading indicator for Germany (TWV-LEI, Germany). TWV-LEI is a composite of the following variables: PMI manufacturing, Ifo business climate index, manufacturing orders, employment opportunities index, inflation expectations, consumer confidence, and the terms of trade. I’ve found that these indices have the highest correlation with current economic activity, which is measured by industrial production. The r^2 of a simple univariate regression of annual industrial production growth on the 5-month ahead leading indicator (annual growth) reveals an 81% correlation – Implied IP is the fitted dynamics of this univariate regression. Unless leading surveys improve dramatically, I expect the German economy to soften much further in coming months.

Using the 1993-2011 time series, the precipitous drop in the TWV-LEI portends a sharp slowdown in German industrial activity, even contraction by December 2011. The implication is that German economic activity, while accelerating in Q3, is likely to contract in Q4.

The policy ramification is clear: It’s going to get a lot more difficult to sell a‘comprehensive solution’ if the leading Euro area economy is in recession.

originally published at The Wilder View …Economonitors

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This ‘Competitiveness’ Thing Is a Scam

By Rebecca Wilder

This ‘Competitiveness’ Thing Is a Scam

What is ‘competitiveness’? It’s an important part of the euro area leaders’ negotiated terms in the July 21st Summit announcement by the European Heads of State. The first paragraph, #4, and #11 of the announcement all refer to this issue of ‘competitiveness’:

We also reaffirm our determination to reinforce convergence, competitiveness and governance in the euro area.

create a Task Force which will work with the Greek authorities to target the structural funds on competitiveness and growth, job creation and training.

All euro area Member States will adhere strictly to the agreed fiscal targets, improve competitiveness and address macro-economic imbalances.

It’s not totally clear what they mean by ‘competitiveness.’ However, I note that they separate the term ‘competitiveness’ from ‘macro-economic imbalances’. Current account imbalances across the region should be included in addressing ’macro-economic imbalances’.
Therefore, it’s bigger than the OECD definition of international competitiveness measure of a country’s advantage or disadvantage in selling its products in international markets.

See, ‘competitiveness’ is an elusive concept that is often associated with relative price movements, real exchange rates, or openness to international trade. But if we look at a May 2011 speech given by German Finance Minister, Wolfgang Schäuble, what he (and by association, the Germans) thinks of ‘competitiveness becomes more clear (h/t Marshall Auerback and bold by yours truly):

“All Eurozone governments need not only convincingly demonstrate their commitment to fiscal consolidation but also to increasing competitiveness to restore confidence of markets as well as their citizens.

Besides, one does not resolve one’s own problems of competitiveness by asking others to become less competitive and one cannot permanently close the gap between expenditure and income by asking others for more money.

the Eurozone has to put additional emphasis on strengthening the competitiveness of all its members. Consumption developments, bubbles in housing markets and the accumulation of external and internal debt in some Member States deepened the impact of the crisis and constrained the capacity to respond. This is why a new procedure for detecting and correcting economic imbalances will be introduced. This procedure will concentrate on curing the root causes of macroeconomic deficits by forcing Member States to ensure a high level of competitiveness.

Competitiveness is about strong macro-prudential policy, infrastructure, efficiency and income gains, saving, etc. Schäuble used the word ‘comopetitiveness’ 14 times in this speech – it’s an important part of his (and perhaps more broadly Germany’s) vision of the euro area’s structural construct. After reading the speech, you realize ‘competitiveness’ isn’t just about international trade and exports, it’s about the efficiency of an economy as a whole.

Now we’re on to something. The World Economic Forum measures competitiveness as a composite of various factors that describe institutions, infrastructure, macroeconomic environment, health and primary education, higher education and training, goods market efficiency, labor market efficiency, financial market development, technological readiness, market size, business sophistication, and innovation (.pdf link here, and composite technicals listed on .pdf page 49). The chart below illustrates the rankings of the euro area 12 and the USA (for comparison) as measured by the percentage of countries that rank below it across 142 developing and developed economies (.pdf page 15).

(Click to enlarge chart)

In 2011-2012, Germany ranks #6 out of 142 countries, where 95 of the 142 countries are less competitive than Germany. Also ranked below Germany is every euro area economy except Finland. So when a German finance minister says that he wants economies to increase competitiveness, he’s effectively saying that he wants economies to be more German. From the bottom up, countries should reform their education, financial markets, business sophistication, innovation, etc., all the while emulating those institutions in Germany.

Better put: being asked to increase competitiveness is really a scam to get these economies to become more ‘German’. If I were Italy or Spain or even Ireland (who by the way is very open but less ‘competitive’ according to this measure), I’d have a problem with that.

originally published at The Wilder View…EconoMonitor

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Angry Bear contributor now at Economonitor

Angry Bear contributor Rebecca Wilder has begun writing her own column, The Wilder View, at the internationally prestigious Economonitor (Nouriel Roubini).

The Wilder View at Economonitor

Europe: Why the One-Size-Fits-All Solution Won’t Work and

Linking sovereign risk to corporate credit spreads in Europe

…and is interviewed and quoted by Floyd Norris in the New York Times.

Government Debt Doesn’t Tell the Whole Story
New York Times by Floyd Norris

In Ireland, as in Spain, the government paid down debt while private sector grew,” said Rebecca Wilder, an economist and money manager whose blog at the …

You can follow her there in the sidebar feed for other blog contributions.

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More Wilder on Europe today

by Rebecca Wilder

I present some basic statistics to highlight the problem in Europe. In short, there exists a deleterious positive feedback loop between overly leveraged banks and their sovereigns in key markets.

Exhibit 1: European Banks are overly levered. Spanning 2006 through the latest data point, key European banking systems – France, Germany, and Italy – increased leverage.

The chart above illustrates the ratio of bank assets to capital (see the IMF’s Financial Soundness Indicators for the data and description of ‘capital’). The countries are ranked by largest % drop in bank leverage spanning the period 2006 to current (Greece, Austria, and Belgium) to the largest % surge in leverage spanning the same period (France, Italy, and the UK). Note: the 2006 data is taken from the 2007 IMF Global Financial Stability Report.

The level of leverage is not strictly comparable across countries due to differences in national accounting, taxation, and supervisory regimes. However, while the US banks have delevered over the period, the big European banks – Germany, Italy, and France – have increased leverage. Assets need to be written down.

Exhibit 2. While leverage is too high, asset quality is dropping. The banks are increasing exposure to government loans and securities relative to traditional loans.

The chart illustrates the nominal stock of loans held on the bank balance sheets of the Monetary Financial Institutions in Europe. The data are from the ECB. Loans to governments and holdings of government securities are increasing more swiftly than traditional lending.

Exhibit 3. The asset quality of that rising stock of loans to the government sector is deteriorating…quickly. Italian and Spanish 10yr bonds are 1.5% and 1.2% higher, respectively, since the beginning of 2010, while German 10-yr yields are 1.5% lower.

The chart illustrates the 10-yr bonds across the euro area bond markets. The latest data point (today around 12pm) is listed in the legend.

Bond investors are clearly differentiating between the riskier bonds – Spain, Portugal, and Belgium – from the ‘core’ – Germany, Netherlands, Austria, Finland, and yes, France. Whether or not bond markets are right to regard Finland or France as ‘core’ is a different matter entirely. But the point is clear: bond markets are in crisis mode, and there’s a stark segmentation in yields across the region.

Cross border exposure dictates that some of these highly levered banking systems are exposed to the same government securities currently trading at distressed levels. A case in point is France with outsized exposure to Italy and Greece (see Table 9B). This is a helpful graphic by Thomson Reuters .

Rebecca Wilder originally at Newsneconomics

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