Wednesday, October 29, 2008

The Bank Bailouts Are Very Well Intended, But Where Is All The Money Going To Come From?

As every woman who has ever had dealings with a man knows only too well, it is a lot easier for people to make promises than it is for them to keep them. And when Europe's leaders met in Paris on the 12 October, a lot of fine promises (which were all, surely, very well intentioned) were made. The reality of having to live up to them, however, is turning out, as might only have been expected, to be much more complicated.

Basically, the kernel of the plan which is now being operationalised seems to have been thrashed out in Washington on 11 October, when key G7 leaders met with Dominique Strauss Kahn of the IMF, and it was decided to try and erect two great firewalls (corta fuegos) - at least as far as Europe is concerned. One of these was to be co-ordinated by the EU governments, and the other by the IMF, who were to act in the East. Both these parties essentially agreed to guarantee the banking systems in the countries for which they took responsibility, so the action, in a sense, moved from the banks (which are now, more or less "safe") to the governments and the IMF (who is ultimately backed by cash from governments), and it is the "safety" of these institutions which is likely to be more or less tested by the markets, with the first trial of strength taking place right now in Iceland.

So the big question now is, do these various institutions have the resources to back up their guarantees, should the need arise?

Problem Selling Bonds

In this context the Financial Times had a very interesting article yesterday about the fact that the Austrian government had decided to cancel a bond auction.

Austria, one of Europe’s stronger economies, cancelled a bond auction on Monday in the latest sign that European governments are facing increasing problems raising debt in the deepening credit crisis.
According to the FT article the difficulties Austria, which has a triple A credit rating, is facing only serves to highlights the extent of the deterioration in the sovereign bond market, where benchmark indicators of credit risk such as the iTraxx index hit fresh record spreads yesterday.

Austria now is the third European country to have cancelled a bond offering in the last few weeks - in the Autrian case the markets are getting more and more nervous over the exposure of some of its key banks (Erste, Raffeison) to the mounting disaster over in Eastern Europe - both Hungary and Ukraine received IMF loans this week (see below) and they certainly won't be the last.

Austria seems to have dropped its plans for a bond launch next week due to the size of the premiums (spreads) investors seemed likely to demand, although the Austrian Federal Financing Agency did not give any explanation for the decision.

Spain, which alos currently has a triple A rating, and Belgium have both cancelled bond offerings in the past month because of the market turbulence, with investors again demanding much higher interest rates than debt managers had bargained for.

So really many European governments are now facing similar problems to those their banks faced earlier, they can get finance, but only at rates which they consider to be punitively high (remember, the interest has to be paid for from somewhere, in the present recessionary climate from cuts in services more than probably, since, remember, if we look over at Eastern Europe, investors are very likely to "punish" those governments who try to go down the easy road, and run large fiscal deficits over any length of time).

Market conditions have steadily deteriorated in recent days with the best gauge to credit sentiment, the iTraxx investment grade index, which measures the cost to protect bonds against default in Europe, widening to more than 180 basis points, or a cost of €180,000 to insure €10m of debt over five years, on Monday.
This is a steep increase since only as recently as Monday of last week, when the index closed at 142 base points. Also the cost of default protection on European companies has risen to record highs this week on investor concern that the global economic slowdown will curb company profits. The Markit iTraxx Europe index of 125 companies with investment-grade ratings fell 3.5 basis points yesterday to 166.5, after hitting a record high on Monday.

The FT cites analyst warnings that the there is now a huge quantity of government debt building up in the pipeline, and the government bonds due to be issued in the fourth quarter and early next year will only add to the problems some countries are facing, and particularly those countries like Greece and Italy who already carrying large amounts of debt that needs to be refinanced or rolled over.

It has been estimated that European government bond issuance will rise to record levels of more than €1,000bn in 2009 – 30 per cent higher than 2008 – as governments seek to stimulate their economies and pay for bank recapitalisations.

The eurozone countries will raise €925bn ($1,200bn) in 2009, according to Barclays Capital. The UK, which is expected to increase its bond issuance from the current €137.5bn in the 2008-09 financial year, will take the figure above €1,000bn.

Italy, and Greece, both with a debt-to-GDP ratios of over 100 percent, are certainly the most exposed to continuing difficulties in the credit markets, (with analysts forecasting that Italy alone will need to raise €220bn in 2009). At the present time the Libyans are lending the Italian government a helping hand (and here) in struggling forward, but even oil rich Libya doesn't have the money to fund the long term needs of the Italian banking, health and pension systems.

IMF Have Only $250 Billion

On the other hand Bloomberg had an article yesterday on the growing pressure on the IMF's somewhat limited resources, as one country after another in Central and Eastern Europe joins the "consultation queue" in the hope of getting a bail out.

Bloomberg report that the cost of default protection on bonds sold by 11 emerging-market nations has now either approached or surpassed distress levels, raising the very immediate likelihood that the International Monetary Fund's ability to bailout countries may soon start to be put to the test.

Credit-default swaps on eight countries including Pakistan, Argentina and Russia have now passed the 1,000 basis points mark, the level which is normally considered to signify "distress", according to data provided by CMA Datavision. Funding one basis point on a contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

``The resources of the IMF may not be sufficient for wider bailouts if needed,'' said Vivek Tawadey, head of credit strategy at BNP Paribas SA in London. ``If it can't raise the money, some of the more distressed emerging markets could end up defaulting.''
Ukraine, Hungary, and Iceland have already received IMF loans, while the fund is currently in "consultation" talks with Belarus, Turkey, Latvia, Serbia, Romania, Bulgaria and Pakistan, at the very least.

According to Simon Johnson, former chief economist at the fund the IMF only has up to $250 billion it can currently lend (as quoted in the Financial Times yesterday).

Credit-default swaps on Pakistan currently cost 4,412 basis points. Contracts on Argentina are at 3,650 basis points, Ukraine at 2,850, Venezuela at 2,400 and Ecuador costs 2,072. Default protection on Russia, Indonesia and Kazakhstan also costs more than 1,000 basis points, while Iceland costs 921, Latvia 850 and Vietnam 837. Contracts on Turkey cost 725 basis points.

The IMF agreed at the weekend to lend Ukraine $16.5 billion for 24 months and stated yesterday that they would contribute $12.5 billion towards a $25.5 billion loan for Hungary (with the other participants being the EU and the World Bank. Iceland got a $2 billion loan on Oct. 24 and Belarus has asked for at least $2 billion. Just how many more loans are now in the pipeline, and if the IMF does start to see its funds stretched, just who exactly is going to step up to the plate and fork the necessary money out? The sheer fact that they only put part of the cash for the Hungarian loan, and that the World Bank had to come on board with a symbolic $1 billion shows they are already aware that the problem may arise.


Well just after writing this, I see from reading the FT that Gordon Brown got there just before me. Beaten by a short head!

Gordon Brown on Tuesday spearheaded calls for a multi-billion pound "bail-out fund" to prevent the global crisis spreading to more countries, and warned of the need to stabilise economies "across eastern Europe".....

The prime minister on Tuesday urged the oil-rich Gulf states and China to provide "substantial" funding to the International Monetary Fund, before flying to France for talks on an increase to the European Union's bail-out fund. The government is keen to emphasise the link between global action and domestic voters' interests, as well as portraying Mr Brown as a world leader.

The prime minister said it was "in every nation's interests and the interests of hard-working families in our country and other countries that financial contagion does not spread". While he did not rule out the UK making a contribution, he insisted the "biggest part can be played by the countries that have got the biggest [balance of payments] surpluses".

The IMF's $250bn (£158bn) bail-out fund "may not be enough" to prevent the crisis destabilising more countries, Mr Brown said. His spokesman added the UK was "looking at a figure in the hundreds of billions of dollars" for the IMF. Mr Brown called for "action on this new fund immediately".

Also, another story in Bloomberg gives us a further glimpse of how the EU governments are planning to do all that financing. The German government, it seems, is going to print IOUs (sorry, bonds) and give them directly to the banks. That is, they are not going to auction bonds and give the proceeds, they are simply giving the paper, and presumeably paying a coupon (or interest). Oh yes, and the bonds will not be sellable, since this would, of course, damage the yield curve via the supply and demand process, but they will count as debt, which means that the German government is being very naieve here (assuming the report is accurate) since of course the rise in the debt may well mean a breach of the 2011 balanced-books commitment, and falling back on this will almost inevitably have an impact on the extra implied risk investors will be looking to get paid for holding the bonds.

Germany plans to finance part of its 500 billion euro ($636 billion) bank rescue package by issuing bonds to banks in exchange for new preferred stock, according to Finance Agency head Carl Heinz Daube.

``The banks will not be allowed to sell the injected government bonds,'' Daube said in an interview in Tokyo today. ``So far there's obviously not a huge demand for any rescue measures, but this might change in the coming weeks.''

Germany's rescue plan, approved by lawmakers on Oct. 17, amounts to about 20 percent of the gross domestic product of Europe's biggest economy. Chancellor Angela Merkel's administration pledged 80 billion euros to recapitalize distressed banks, with the rest allocated to cover loan guarantees and losses.

....Hypo Real Estate Holding AG, the Munich-based lender that's already had a 50 billion euro bailout, today asked the Deutsche Bundesbank for 15 billion euros to cover short-term liquidity needs. ....Frankfurt-based Deutsche Bank AG may also need 8.9 billion euros of new capital, more than any bank in Europe, Merrill Lynch & Co. analysts Stuart Graham and Alexander Tsirigotis wrote on Oct. 20.

The bailout plan is still being discussed in Berlin and more information will probably be released at the end of this week, Daube said.

Germany may meet additional funding needs for its bank rescue by selling six-month bills before examining options for borrowing using longer-term securities, Daube said. The government plans to offer between 212 billion euros and 215 billion euros of debt through its 2009 program, about the same as the 213 billion euros scheduled for this year.

The debt-for-equity swap will probably have ``next to no effect'' on the country's yield curve because the notes offered to banks won't trade in the so-called secondary market, he said. The yield curve plots the rates of government bonds according to their maturities, and increases indicate higher borrowing costs.

``The government deficit of course will increase, the outstanding volume of bonds will increase as well,'' Daube said. ``The number of outstanding bonds available in the secondary market will stay exactly the same.''

Gentlemen, we are out of our depth here.

Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Monday, October 27, 2008

German Business Confidence Worsens Significantly In October

German business confidence hit its lowest level in more than five years in October as the deepening financial crisis started to have an effect on the outlook for economic growth. The Munich-based Ifo institute business climate index, which is based on a survey of 7,000 executives, fell to 90.2, its weakest reading since May 2003, and down from 92.9 in September.

If we have a look at the evolution of the index sub-components, we can see that the retailing and construction sectors have long been plumbing the bottom. What is new over the last few months is that the manufacturing sector has steadily been joining them as export growth has weakened. This means quite a sharp recession is on the way in Germany, in my opinion. Germany's leading economic institutes this month slashed their joint forecast for growth in what is Europe's biggest economy for next year, forecasting an expansion of just 0.2 percent in 2009, and even this may well turn out to be excessively optimistic - the risk of annual contraction is now a non-negligable one, especially if we are going by the Federal Statistics Office Non-calendar-adjusted reading, since there will be one working day less in 2009.

Germany exports fell for a second month in August while German investor confidence dropped for the first time in three months in October, to near a record low. The ZEW Center for European Economic Research said its index of investor and analyst expectations slumped to minus 63 from minus 41.1 in September. The index all time low is minus 63.9 which was in July of this year.

Deceleration in Germany's Manufacturing Sector Accelerates

" This impression is only confirmed by October's falsh PMI reading which indicated the sharpest decline in German private sector activity since mid-2003," Tim Moore, an economist at Markit Economics, said in a statement. "Market demand was shaken by the latest global financial turmoil, as firms became increasingly concerned about the economic outlook and access to credit."

The rate of expansion in the German economy seems to have dropped back to its lowest level in more than five years in October. The preliminary flash estimate of the composite purchasing managers' index for what is the euro zone's biggest economy fell to a 64-month low of 46.7 in October from 48.5 in September. Manufacturing activity in contracted for the third straight month with the reading plunging to 43.3 from a final reading of 47.4 in September.

In addition, economic activity in the service sector stalled for the first time since January as the flash reading slipped to 49.7 from 50.2.

However, the data showed input price inflation eased to its slowest for more than three years in October, with the month-on-month fall in the index was the largest since the series began in January 1998. This reinforces data out this morning (Friday) from the German Federal Statistics Office which showed that German import prices fell 1.0% month-on-month in September after declining 0.8% in the August, as crude oil prices continued to pull back from their record high in July. On an annual basis, the rate of import price increase slipped back to 7.6% from 9.3% in August.

The data suggests that the German economy may well continue to be in recession in the fourth quarter (assuming that the forthcoming 3rd quarter data do show a contraction) as demand across the global economy continues to falter, a process which will hit an export dependent economy like the German one especially hard.

Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Friday, October 24, 2008

Eurozone October PMI's Indicate Sharp Recession In The Works

“The latest flash PMI indicates the alarming extent to which the financial crisis has developed rapidly into an economic crisis, with the Eurozone economy contracting at the fastest rate for over ten years in October. Manufacturers are the hardest hit, with the sector contracting at a pace exceeding even the most pessimistic of forecasts polled by Reuters.
Chris Williamson, chief economist at Markit.

The eurozone economy continued the contractaction registered in the third quarter in October at a speed not seen since the start of the euro in 1999, with the kock-on effects of the global bank crisis hitting manufacturing industry especially hard, and making a huge dent in industry’s order books.These are the grim conclusions which can be drawn from the latest - Flash - Purchasing Manager Index (PMI) readings for the economies of 15-country currency zone. The low readings registered are provisional, but experience shows that they are unlikely to be that far off the mark, and they obviously make even more likely substantial cuts in European Central Bank interest rates over the coming months, especially since price pressures also cooling rapidly as overcapacity issues yawn before us. The results only serve to add to concern that the recession which the eurozone in all likelihood entered on April 1 2008 that will prove to be a long drawn out and protracted affair.

Eurozone Composite Reading Falls Sharply

- Flash Eurozone Services Business Activity Index at 46.9 (48.4 in Sep.); lowest since Oct. 2001

- Flash Eurozone Manufacturing PMI(3) at 41.3 (44.5 in Sep.); new record low

- Flash Eurozone Manufacturing Output Index(4) at 40.5 (44.1 in Sep.); new record low

The Markit Flash Eurozone Composite Output Index sank to a new record low in October, signalling the steepest monthly reduction in private sector output since the survey data were first compiled in July 1998 and the fifth successive monthly contraction.

Output fell at a new record pace in manufacturing, while services activity showed the second-sharpest deterioration ever recorded, with the decline exceeded only by that seen in October 2001. Expectations of business activity in 12 months' time in the service sector plummeted and hit a new record low - and by a wide margin. Falling output and business confidence were linked to a record monthly drop in demand for goods and services, as measured by the composite new orders index. Overall, new orders have now fallen for six consecutive months.

The “composite” purchasing managers’ index, covering manufacturing and services, slumped from 46.9 in September to 44.6 in October, the lowest since the survey began in July 1998. A figure below 50 is taken to indicate a contraction in activity. Eurozone manufacturers’ new orders fell at the sharpest rate recorded, led by a slump in export orders. Service sector new business did not contract as fast but still saw the second steepest fall on record.

We only have a breakdown of country secific indices for France and Germany, and French manufacturing is evidently performing a lot worse than its German equivalent, although the contraction in German industry is getting sharper by the month, and anecdotal evidence does suggest that there may be much worse to come as demand from the very important customer base in Eastern Europe comes virtually to a dead stop in the wake of the credit crunch. So even Germany saw private-sector output contracting for a second consecutive month, and business sentiment for the next 12 months sank to the lowest level registered there since records began in June 1997.

The composite reading for manufacturers' new orders fell at the steepest rate yet registered by the survey, led down by a record fall in new export orders. In comparison, new business in the service sector showed a more modest rate of decline, though still posted the second largest contraction yet seen by the survey.

Input price inflation, on the other hand, having hit a near-eight-year high back in July, eased back again for the third successive month in October, dropping to the weakest pace since July 2005. The monthly fall in the rate of price increases was the sharpest ever recorded by the survey, led by a steep easing in manufacturers' input price inflation, which in turn reflected lower commodity prices and an increased willingness among suppliers to cut prices to sell stock. Input cost inflation also moderated in the service sector.

Output prices rose only slightly during the month, the rate of increase having slowed for the third successive month from July's record high to reach the weakest since December 2005. Upwards pressure on charges was alleviated by weaker growth of input costs, but also reflected discounting in the face of falling demand.

“Price pressures are collapsing alongside falling demand, which will hit profits further but will help pave the way for lower interest rates.” Chris Williamson, chief economist at Markit

Deceleration in Germany's Manufacturing Sector Accelerates

"October's PMI indicated the sharpest decline in German private sector activity since mid-2003," Tim Moore, an economist at Markit Economics, said in a statement. "Market demand was shaken by the latest global financial turmoil, as firms became increasingly concerned about the economic outlook and access to credit."

The rate of expansion in the German economy dropped back to its lowest level in more than five years in October. The preliminary flash estimate of the composite purchasing managers' index for what is the euro zone's biggest economy fell to a 64-month low of 46.7 in October from 48.5 in September. Manufacturing activity in contracted for the third straight month with the reading plunging to 43.3 from a final reading of 47.4 in September.

In addition, economic activity in the service sector stalled for the first time since January as the flash reading slipped to 49.7 from 50.2.

However, the data showed input price inflation eased to its slowest for more than three years in October, with the month-on-month fall in the index was the largest since the series began in January 1998. This reinforces data out this morning (Friday) from the German Federal Statistics Office which showed that German import prices fell 1.0% month-on-month in September after declining 0.8% in the August, as crude oil prices continued to pull back from their record high in July. On an annual basis, the rate of import price increase slipped back to 7.6% from 9.3% in August.

The data suggests that the German economy may well continue to be in recession in the fourth quarter (assuming that the forthcoming 3rd quarter data do show a contraction) as demand across the global economy continues to falter, a process which will hit an export dependent economy like the German one especially hard.

French Manufacturing Now In Sharp Retreat

French manufacturing activity contracted at its fastest pace in a decade in October, while new orders in both manufacturing and services fell at their sharpest pace in 10 years. The flash estimates of the Markit/CDAF PMI showed the headline figure for manufacturing fell to 40.8 in October, its lowest since data was first collected in April 1998, from 43.0 in September.

The services sector, which accounts for around two-thirds of the euro zone's second largest economy, saw its index slip to 48.8 from 50.1 in September, while the new orders sub component fell to 45.3 - its lowest since the survey began in May 1998.

With the new order index for manufacturing also hitting a series low - it fell to 34.7 in October from 37.5 in September, all the indications are that tough times lie ahead given the extent of the worldwide economic slowdown.

According to the latest estimate from France's national statistics office INSEE, the French economy contracted in Q3 2008, if that is the case I am left asking myself which of the big four eurozone economies could possibly be expected to have expanded in the July to September period. Certainly not the Spanish one, which while not technically in recession yet (you need to consecutive quarters of negative growth to classify as being in recession) can hardly have expanded. The German economy almost certainly contracted, and while the Italian one could sneak a surprise "horses-nose" expansion (given the low level it had reached in the 2nd quarter) I think it is unlikely. So here we go - recession in the eurozone.

France's gross domestic product probably shrank by 0.1 percent in the third quarter after a contraction of 0.3 percent in the three months through June, according to the latest Insee estimate. The economy is also likely to shrink 0.1 percent in the final three months to cut growth to 0.9 percent for the full year, the slowest pace since 1993, Insee added.

"Unfortunately nothing here indicates that we've hit bottom," said Chris Williamson, chief economist at Markit. "The availability of credit is definitely becoming a problem and if that doesn't turn around quickly then output numbers will probably follow those order book numbers down."

Italian Business Confidence in Free Fall

Both Italian Business and Consumer Confidence fell back in October. Between the battering the Italian banking sector is taking on the one hand, and the ongoing contraction in the real economy on the other, Italy isn't exactly in the best of shape right now. Unfortuantely, despite years of warnings little was done, and now all the chickes come home to roost, and, as if in an illustration of what the expression "worst possible case scenario" means, they all come home to roost at once.

Italian business confidence sliiped to its lowest level in 15 years in October while consumer optimism eased back as the global financial crisis darkened the economic outlook and offset the positive effects of cheaper oil prices. The Isae Institute's business confidence index fell sharply to 77.7 from a revised 81.8 in September, according to the news release from the Rome-based research center earlier this morning (Friday).

Consumer confidence also slipped nack, falling to 102.2 from 102.8. Interestingly the drop in consumer confidence is not as sharp as that in business confidence, and we are still above the July low point (when oil prices hit a maximum), but the outlook for Italian households can scarcely be better than that for Italian corporates at this point. Perhaps the financial news just takes longer to sink in, while the impact of falling oil prices is pretty immediate, at least on the consumer outlook.

Even before the outbreak of the latest round of financial turmoil Italy's economy was in all probability in recession after contracting 0.3 percent in the second quarter. Confindustria expect the Italian economy to actually contract in whole year2008, while the Isae Institute recently cut their own forecast for Italian growth, saying the economy would stagnate this year (ie neither expand nor contract), putting in the worst performance since 2003. In the short term things can only deteriorate from this position as the growing shock from the financial sector continues to pound the Italian real economy.

Spain's Unemployment On The Rise

Spanish unemployment hit a four-year high in the third quarter of this year as tens of thousands of jobs are lost every month as the decade-long housing boom comes to an end.

According to data published today (Friday) by Spain's National Statistics Institute, the jobless rate rose to 11.33% in the third quarter from 10.44% in the second quarter. Lest we get confused here, there are two different systems for collecting data, one a monthly labour survey (based on interviews) on the basis of which the quarterly reports are prepared, and which go into the National Accounts (for GDP measurement purposes) and the monthly report from the Labour Office (or INEM). In some ways the latter give a better day to day comparison of the evolution of jobless trends, and the next one of those will be out at the start of November.

According to the September INEM report the number of people out of work in Spain rose to an 11-year high in September, and this was the sixth consecutive month which has seen an increase. The number of job benefit claimants rose by 95,367 in September, up 3.7 percent from August, to 2.6 million, the highest since May 1997. This was considerably above what many analysts had been expectating and the trend is likely to continue. Personally I don't think there can now be any doubt about it, what is likely to become the longest running recession in Spanish history started on 1 July 2008. That's a historic date now. Make a note of it somewhere. For your grandchildren, perhaps.

In their accompanying statement, INE said that 78,800 jobs were lost in Spain during the three months to Sept. 30. The INE also said 164,300 jobs had been lost since September of last year, and this was the first time the total number of jobs had declined on an annual basis since 1994.

Until the financial crisis began in August of last year, Spain had been one of Europe's engines of economic growth and job creation. Largely thanks to a massive home-building boom, the eurozone's fourth largest economy created over a third of all new jobs (and consumed more cement than any other single member country) in the single-currency area over the last decade.

This boom allowed Spain's historically high unemployment rate to fall to just under 7.95% in the second quarter of 2007. But as the housing boom has slowed (from January 2007) and then collapsed following the onset of the global financial crisis all this has changed. With home sales and new home starts now in free fall, the INE said 354,000 construction sector jobs were lost in the third quarter from the same period a year earlier.

According to internationally comparable monthly data released on Oct. 1 by Eurostat - the European Union's statistics coordinator - Spain had an 11.3% unemployment rate in August, the highest among the European Union's 27 member countries.

Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Sunday, October 19, 2008

Training Session on the Spanish Bank Bailout Plan

Keynes, however, once semi-seriously proposed, as an anti-deflationary measure, that the government fill bottles with currency and bury them in mine shafts to be dug up by the public.
Ben Bernanke, Deflation: Making Sure "It" Doesn't Happen Here
Many of the macro-economic fundamentals of Spain today are very different from those of ten or fifteen years ago...........A lot of factors look better this time around. Compared to its history, Spain has low interest rates, low unemployment and a strong fiscal position........the 2007 levels of government debt, unemployment and interest rates are about half the level of 1993. Equally, a lot of factors related to debt levels, housing and bank funding are worse versus the last downturn. For instance, the relative size of mortgage debt or total private sector debt to GDP, or the size of the construction sector to GDP, were all about 60% bigger in 2007 than in 1993. As was the bank system’s loan-to-deposit ratio. And the housing PE has expanded almost as much. So when Spanish bank management’s argue that the world today is not like the early 1990s, they are right: some things are better, but others are worse. As Mark Twain noted many years ago, history may not repeat itself but it does rhyme.
Spanish Banks, How Bad Can It Get? - Citigroup, September 2008

As I suggest in the title, the contents of this post resembles more an online training session about how the recent proposals to refloat and reinforce the Spanish banking sector may work out in practice than a conventional blog post, but still, this is the weekend, and at weekends, as well as all that interminable football, hiking and tapas snacks in bars, people are supposed to enjoy complementary and value-enhancing activites like going on courses, aren't they? So why don't we have a try. But remember, this topic is only for those with the sternest of stomachs, and the greatest of abilities to find - now what was the word Krugman recently used, ah yes, beauty - in that otherwise most arid of landscapes, the world of financial book-keeping.

So, as is the custom in all good training sessions, let's all start by watching a video, just to get us in the mood, and into the swing of things as it were. I think after the viewing what follows may be a lot more digestable, and certainly it should be more comprehennsible. (The version is conveniently supplied with substitles in Castellano the benefit of any Spanish speaking readers who might drop by).

Saturday, October 18, 2008

Colonialism Moves Into Reverse Gear As The Libyan Government Bails Out Unicredit

Taking my cue from the worthy and well thumbed play-book of the Brothers Coen, I thought every now and again I might follow up all those, long, desperately serious, and highly indigestible posts about how Italy should now be considered to be "No Country For Old Men", with something in rather lighter vein.

The highly acclaimed and award winning Miss Iceland Look-alike show is not the only prime time TV talent contest we are going to see over the coming weeks and months it seems. We are also apparently on the verge of watching a beefed up and much more macho version, whose pilot screenings have now been launched under the working "Man-City/Emirates Stadium" look-alike title, since news today informs us that the Libyan government is at this very moment in the process of bailing out Italy's much troubled banking system (following in the well trodden footsteps of AC Milan, who were, it seems, able to partially finance the acquisition of the the world's former number one footballer - Ronaldinho Gaucho - thanks to a fundraising trip to the Arab Emirates).

UniCredit SpA surged after Libyan investors including its central bank boosted their stake in Italy's biggest bank and said they will invest more. The shares gained as much as 12 percent to 2.42 euros in Milan, valuing the bank at 32.2 billion euros ($42.4 billion). Libya's investment is ``good,'' UniCredit Chief Executive Officer Alessandro Profumo told reporters in Milan. ``It's a confirmation of their interest in our company, which they also consider to be very attractive.''

The investment may be worth much as 1.3 billion euros, according to a note by Centrosim analyst Marco Sallustio published this morning. It could allow Libya to obtain a seat on the bank's board. Central Bank of Libya, Libyan Investment Authority and Libyan Foreign Bank bought shares to boost their holding to 4.2 percent, the investors said in a statement late yesterday. They intend to buy as much as 500 million euros of securities that UniCredit plans to sell over coming months.

But then, where do you imagine that the greatest risk to the viability of Italy's Unicredit lies? And what do think is the the principal reason why both Italy and its banking system need this sudden Libyan support? Well you might try looking "over there", you know, where they are holding the Miss Iceland look-alike contest.

Here, courtesy of Reuters, are some basic facts about Unicredit:

- - UniCredit is one of Europe's top 10 banks by market value, with a capitalisation of about $39 billion. It is second to Intesa Sanpaolo SpA among Italian banks.

-- In a U-turn on Oct. 5 it announced plans to boost capital by 6.6 billion euros. It will ask investors for 3 billion euros in a capital increase and offer shares rather than a cash payout on 2008 results, putting 3.6 billion euros instead in its own coffers.

-- UniCredit on the same day boosted its target for Core Tier I to 6.7 percent at the end of 2008 based on Basel II requirements from its previous aim of 6.2 percent. The figure was 5.7 percent at the end of June.

-- It also slashed earnings per share forecasts for this year to 39 euro cents from around 52 euro cents previously.

-- It is the Italian bank with the most foreign exposure. UniCredit gets about half its revenue from outside Italy and its conservative lending market.

-- UniCredit, whose units include Germany's HVB, is among market leaders in Germany and Austria.

-- UniCredit's share price has dropped about 62 percent since the start of the year, pushing it second to Intesa Sanpaolo among Italian banks. The DJ Stoxx European banks index has lost about 52 percent.

-- First-half net profit was 2.9 billion euros on operating income of 14 billion euros. Deposits from customers and debt securities totalled 639.8 billion euros.

-- The bank traces its origins back to 15th century Bologna. The current UniCredit resulted from the merger of nine of Italy's biggest banks in 1998, as well as the purchase of HVB in 2005 and Italy's Capitalia last year.

-- The biggest shareholder is the Fondazione Cassa di Risparmio di Verona Vicenza Belluno e Ancona, at 5 percent.

-- Libya now comes second with its combined 4.23 percent, followed by:

Fondazione Cassa di Risparmio di Torino with 3.83 percent

Carimonte Holding with 3.35 percent

Gruppo Allianz with 2.37 percent

Fondi Barclays Global Investors UK Holdings Ltd with 2.01 percent.

-- UniCredit is the biggest shareholder in powerful investment bank Mediobanca SpA with an 8.7 percent stake.

Evidently, in this type of business, what you pay for is what you get:

Italian Prime Minister Silvio Berlusconi pledged $5 billion over 25 years to Libyan leader Muammar Qaddafi in compensation for the occupation of the country in the 30 years before World War II.

Italy will pay $200 million per year to Libya in the form of investments in infrastructure. The money will finance the construction of a coastline highway that runs about 1,600 kilometers (994 miles) between the Egyptian and Tunisian borders.

``It's a full moral recognition of the damage done to Libya during Italy's colonial period,'' Berlusconi said after arriving at the airport in the Libyan city of Benghazi, where the two leaders met to sign the accord. ``This will end 40 years of misunderstandings.''

And why, we might ask ourselves, does the Italian government find itself in need of such recourse to what we might now term "the Libyan Connection" in order to recapitalise its banks. Well, Global Insight in a very informative recent survey of the recently adopted EU government commitments to the banking sector perhaps offer us one part of the explanation: quite simply, after years of letting the public finances drift, Italy simply doesn't have any borrowing capacity left with which to raise the necessary money itself, since with debt at around 104% of GDP, people - apart from those ever so kind Libyans that is - have become increasingly reluctant to lend it to them.

In a deviation from the measures seen in France and Germany, Italy has not created a fund for its rescue plan, with Finance Minister Giulio Tremonti stating that, "As of today, we estimate that it's not necessary to have a predetermined figure."......Italy is in stark contrast to other European nations by providing no firm capital commitments; however, the government's reluctance to create a rescue fund could partly be a reflection of the restraints imposed by its substantial public debt, which stood at 104% of GDP in 2007.

So, as I said, with people becoming increasingly apprehensive about buying Italian government paper, then having rich and obliging friends like the Libyan government is going to be a real boon. Oh yes, but of course when I said "people" in the last sentence, I wasn't, of course, including, at least for the moment, that other untiring friend and trusted workhorse the Italian government can still count on for support over at the ECB in Frankfurt.

The Bank of Italy will also engage in a 40-billion-euro debt swap, taking on inferior bank debt for government bonds that can then be used to obtain financing from the ECB.

So don't let yourself get behind the curve, and don't miss out on the very latest talent-stalking trend towards ever more exotic varieties of global look-alike contests. Now which country was it where the banks were being busily underwritten by the Shanghai Pudong Development Bank, just let me go and check my records......?

Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Monday, October 13, 2008

Europe's Leaders Agree To A Common Front In Fighting The Banking Crisis

Well, Europe's leaders have finally bitten the bullet. Faced with what IMF head Dominique Strauss Kahn warned could turn into a global financial meltdown, our leaders have risen to the challenge, at least to a certain extent. The details of what has been agreed continue to remain vague, but obviously I think it is a good FIRST move. More will now almost inevitably follow, but our reluctant leaders have finally got their feet wet, and the bathing costume is on. Now it is only left for them to dive into the ocean which lies in front.

And, of course, the situation was not without its theatricals. Initially billed as a "eurozone only" meet-up, Gordon Brown was ultimately summoned, a move which was not totally essential, but since he was the only one with a real "going plan" on the table, the invitation made sense. Of course Brown himself has been relishing it all, proudly proclaining that Britain will "lead the way" out of the credit crunch, and adding in true Churchilian style that "I've seen in the cities and towns I've visited a calm, determined British spirit; that, while this is a world financial crisis that has started from America, Britain will lead the way in pulling through."

Well, we will see.

While the details at present remain vague the important point would seem to be that Europe's leaders have made a commitment not to allow any systemic bank - in Western Europe (the guarantee does not extent to Hungary which today had to turn to the IMF for support) - to go bust, and it will now be hard for them to go back on this without losing all credibility. The deposit guarantees - which may be useful in terms of reassuring the general public - would now seem to be largely redundant, since if the large banks, and their debts, are to be guaranteed, then logically the deposits themselves are safe. And while Europe itself will underwrite the systemic banks, the national governments will be able to handle the smaller ones (Spain's regional cajas etc) at local level.

So government finances will guarantee the banks, but who will guarantee the government finances? This, at this stage may seem to be an idle question, since none are under direct threat, but I think we need to be clear here, the money which will now need to be spent - and it is way too early to start trying to put precise numbers - will have to come from somewhere, and by and large this will mean the national governments issuing debt, but if we come to individual national governments like Greece or Italy - where debt to GDP ratios are already over 100% - it is not clear how much paper they can actually issue without seeing what is know as the "spread" on their bonds increasing significantly. So while it is certainly time to breath a sigh of relief, we we far from being able to whistle the all clear. And of course the real economy consequences of what has just happened are pretty serious, and the funds which will be spent propping up the banks will not be available for fiscal stimulas packages, so the bottom line is that we, in the OECD world, may well be in for one of the longest and deepest recessions since WWII.

The Package Itself

Now, as I say, the details we have to date of what has been agreed are far from clear. What is clear is that the EU collectively has agreed to guarantee new bank debt in the eurozone (and possibly elsewhere, but this point still awaits clarification, since as I say the guarantee evidently doesn't apply to Hungary, and that should give us some sort of idea about just how strained everything is at the moment). They are also committed to the use of taxpayers money to keep any systemic banks which get into distress afloat, and by implication they are prepared to pool resources to do this (maybe by injecting funds into the ECB as the UK has pledged to do for the Bank of England). This is also a very important precedent: since the European institutional structure is something of a patchwork quilt at this point, it is clearly make, mend and improvise time.

Wolfgang Munchau clearly seems to catch the spirit of the times in a long and thoughtful article in the Financial Times this morning:

"I had a better feeling about Sunday’s eurozone summit. It produced a detailed and co-ordinated national response to recapitalise the banking system, and to provide insurance to revive the inter-banking market. But as far as I could ascertain, this was still agreement on ground rules for national plans, and it is not clear how well this agreement would cover the numerous cross-border issues that have arisen. There is no doubt that, in the eurozone at least, we have come a long way since Friday. It is an okay policy response, but I wonder whether this is going far enough at a time when global investors are pondering whether to pull the big plug."

Well look Wolfgang, my favourite phrase these days is "sufficient unto the day", we have come as far as we are able to come in one weekend. There will still be next weekend, and the one after. Clearly we have not come far enough yet, but as Paul Newman discovered in a once famous film, there are only so many hard boiled eggs you can eat in one sitting.

The key measures announced at the weekend were: a pledge to guarantee until the end of 2009 bank debt issues with maturities up to five years; permission for governments to buy bank stakes; and a commitment to recapitalize what the statement called `"systemically'' critical banks in distress. The statement gave no indication of how much governments were willing to spend or the size of bank assets deemed to be at risk, and European officials refused to estimate the price tag of the measures. Some indication of the numbers involved will start to emerge today, when France, Germany, Italy and others begin to announce their national measures.

"What has been done over the last three days should provide elements of reassurance,'' Dominique Strauss-Kahn, chief of the International Monetary Fund said on French radio Europe 1 today. The worst of the financial crisis ``may be behind us.''

Often criticized for its preoccupation with inflation, the European Central Bank abruptly reversed course last week, cutting interest rates for the first time since 2003 in a move coordinated with the U.S. Federal Reserve and four other central banks. The ECB doesn't have the legal power at the moment to follow the Federal Reserve and buy commercial paper to unblock a financing tool that drives everyday commerce for many businesses, according President Jean-Claude Trichet, who also participated in yesterday's Paris meeting.

``We are looking at our entire system of guarantees and we can imagine new measures to enlarge access to our system of guarantees,'' Trichet said.

As Wolfgang Munchau points out, there is now an almost unanimous consensus among economists about the need for a recapitalisation of the banking system, and for the provision of some form of public-sector insurance for the money markets, even if there is no consensus about how exactly to do this. We should not forget, of course, that it was precisely the practice of offering guarantees - via instruments like credit default swaps - for what appeared at the outset to be investment grade lending but which later turned out to be extremely risky that has produced the current "near meltdown", and we therefore need to be extremely careful about the kind of guarantees we are offering, since what we do not want to happen is to see public finances meltdown in the future in just the way bank finances have.

What Wolfgang doesn't draw too much attention to - perhaps he is too modest - is how few of us there actually are who have been who have been arguing systematically and repeatedly for just this kind of package of measures since the very start. Wolfgang is one of a very select company here, and I, if I may be so presumptious, am another. Back on July the 18th - in a post for RGE Europe EconMonitor - I said the following (the numbers were pretty rule of thumb, but in the light of what is now coming out they don't look that far off):

So what does all this add up to? Well, to do some simple rule of thumb arithmetic, just to soak up the builders debts and handle the cedulas mess, we are talking of quantities in the region of 500 to 600 billion euros, or more than half of one years Spanish GDP. Of course, not every builder is going to go bust, and not every cedula cannot be refinanced, but the weight of all this on the Spanish banking system is going to be enormous...............So it is either inject a lot of money now - more than Spain itslelf can afford alone - or have several percentage points of GDP contraction over several years and very large price deflation - ie a rather big slump - in my very humble opinion. And it is just at this point that we hit a major structural, and hitherto I think, unforeseen problem in the eurosystem (although Marty Feldstein was scratching around in the right area from the start). The question really we need an answer to is this one: if there is to be a massive cash injection into Spain's economy, who is going to do the injecting? Spain alone will surely simply crumble under the weight, and it is evident that the problem has arisen not as the result of bad decisions on the part of the Spanish government, but as a result of institutional policies administered in Brussels and monetary policy formulated over at the ECB. And yet, the Commission and the ECB are not the United States Treasury and the Federal Reserve, no amount of talk about European countries being similar to Florida and Nebraska is going to get us out of this one: and it is going to be step up to the plate and put your money where your mouth is time soon enough.

Well, getting through to the put your money where your mouth is stage didn't take that long, now did it? Twelve weeks and two days to be exact.

My central point at this stage would be that all of this is going to have, among other things, important implications for the real economy, since it is the degree of all that leveraging which we have been busy doing which is now going to have to be reduced, and while we are all busy "deleveraging", our real economies will notice a significant drop in demand. I wouldn't like to dwell too much on the point at this stage, but this was, of course, precisely what happened in the 1930s.

Basically, one economy after another in the developed world is now going to become export dependent. If I take Spain as an example, perhaps things will be clearer. Spanish households are now in debt to the tune of around 90% of GDP. Spanish companies owe something like 120% of GDP, and the government, which is just about to start accumulating more debt, owes about 50% of GDP. Adding that up, Spain incorporated owes about 260% of GDP at the present time. But the situation is worse than that, since debts continue to mount.

Back in the good old days of Q2 2007, when Spain's economy was busy growing at a rate of about 4% per annum, corporate and household debts were increasing at a rate of about 20% per annum. 4% growth for a 20% rise in indebtedness (or an increase of about 30% in debts to GDP) doesn't seem like that good value for money when you come to think about it - and in the meantime Spain Incorporated's indebtedness to the rest of the world (via the current account deficit) was growing at a rate of 10% per annum. Fast forward to Q2 2008, and household and corporate debts were rising at a mere 10% per annum (and government debt had also started to rise, at this point at a rate of around 2% of GDP per annum, or 4% of accumulated debt), but Spain's economy had reached a virtual standstill (true it was still growing at 1% rate year on year, but quarter on quarter it was virtually stationary). So not only is this a horrible "bang for the buck" ratio, it is also totally unsustainable. Indebtedness has to be reduced, not increased, and this can be done in one of two ways, either by ramping up GDP growth (which in the present environment is out of the question in the short term) or by burning down the debt by paying (or writing) it off.

This harsh but unavoidable reality has two important implications. The first of these is that Spain is going to need external help, and the second is that while the level of indebtedness is being reduced, Spain will not get GDP growth from internal demand, and any headline GDP growth there is will need to come from exports.

And of course Spain is just one (extreme) case. There will be a whole company of others who need to make this transition (the UK, Greece, Denmark, Ireland at least, and probably virtually all of Eastern Europe - now what was that football song I used to sing back then in the old days, over there on the Spion Kop... "when you walk through a storm...").

So the question is, while a host of new countries are suddenly struggling to export, who is going to do all the importing? No mean topic this one. The only person who seems to have even the inkling of a proposal here is World Bank head Robert Zoellick, who came right out with it on Sunday: we need a new multilateral structure. The global financial crisis underscores the need for a coordinated action to build a better system, he said on Sunday. "We need to modernize multilateralism for a new global economy....We need concerted action now to ... build a better system for the future." Never better said, and never was the fact that we live in an interconnected world placed under such a stern spotlight.

And just what will this system look like? Well, the details will all need working out, but in broad brushstroke terms, my strong feeling is that we need to bring-in the large developing economies like India, Brazil, Egypt, the Philippines etc en-bloc, and create a Marshall-Plan-type structure were all those newly created developed world savings can be put to good (and safe) use in facilitating the emergence of those long suffering emerging and frontier markets, and in so doing these countries will play their part by helping provide the customers which our own "export dependent" economies will all now so badly need. But, as I say above, sufficient unto the day......

Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Tuesday, October 07, 2008

Spain's Economy Peers Out Over The Precipice: The Abyss Lies Below

Après Moi Le Deluge

The condition of Spain's economy is deteriorating markedly and rapidly by the month. Output is down, domestic demand is down, exports are struggling, and unemployment is up. The tumultuous events of late August and early September in the global financial markets are now evidently making their presence steadily felt on the real economy. And since Spain's banking and financial crisis continues to trundle on, with no effective remedy whatsoever being offered, the worst is, most definitely, still to come. This is going to be a long hard road to travel for what was once the blue eyed boy among the eurozone economies.

Industrial Output Falls Again In August

Spain experienced another sharp decrease in industrial output in August (down 7.0% year on year). Month on month working day adjusted output plunged by 33.1% in August,
after a marked rebound in July (up by 6.1%), but this is not as dramtic as it seems since industrial production normally falls sharply in August due to annual holidays.

But the year-on-year number, the index fell by 7.0%, folowing a 3.0% drop in July (revised) and a 9.2% one in June (the sharpest fall since a 1993 recession) show that the contraction in Spanish industry is now sharp and severe. August was the fourth consecutive monthly drop, and April only gives the appearance of being positive due to the peculiar March Easter calendar impact which can be noted in even the seasonally adjusted data across the globe.

These results obviously suggest not only that the recession has already begun (contraction in Q3 2008) but that it is likely to be long and deep - more a slump than a recession. If we look at the output index level (which doesn't yet include the August drop since Spain do not publish an adjusted index, and Eurostat have yet to release the EU harmonised data) we can see (below) that output actually peaked in July 2007 (one month before the onset of the credit crunch) and since then has been falling. This trend can be expected to continue for some considerable time to come.

September Global Manufacturing PMI Shows An Even Sharper Contraction In The Works

Spain's manufacturing sector shrank at its fastest pace in at least 10 years in September as output, new orders and employment all fell at a record rate, the Markit Economics Purchasing Managers Index showed on Wednesday. This result is hardly surprising, since September seems to have been the ultimate "mensis horribilis" for industrial output internationally, with global manufacturing activity contracting for the fourth consecutive month, and output falling to its weakest level in over seven years according to the JP Morgan Global Manufacturing PMI, which at 44.2 hit its strongest rate of contraction since November 2001, down from 48.6 in August (Please see the end of this post for some information about countries included and the JP Morgan methodology).

According to the JP Morgan report the retrenchment of the manufacturing sector mainly reflected marked deteriorations in the trends for production, new orders and employment. The declines in output and new work received were the second most severe in the survey history, while staffing levels fell at the fastest pace for over six-and-a-half years. The Global Manufacturing Output Index registered 42.7 in September, well below the 48.5 posted for August.

The sharpest decline in production was recorded for Spain, followed by the US, Japan and then the UK. Although the Eurozone Output Index sank to its second-lowest reading in the survey history, it was above the global average for the first time in four months. Within the euro area, France and Spain saw output fall at survey record rates, while in Italy and Ireland the contractions were the second and third most marked in their respective series. Germany, which until recently was the main growth engine of the Eurozone, saw production fall for the second month running and to the greatest extent for six years. Manufacturing activity in Japan fell to the lowest in over 6- years with the Nomura/JMMA Japan Purchasing Managers Index declining to a seasonally adjusted 44.3 in September from 46.9 in August.

At 40.8 in September, the Global Manufacturing New Orders Index posted a reading well below the neutral 50.0 mark. JP Morgan noted that the trends in new work received were especially weak in Spain, the UK, France and the US, with the all bar the latter seeing new orders fall at a series record pace (for the US it was the strongest drop since January 2001). The downturn of the sector led to further job losses in September, with the rate of reduction in employment the fastest since February 2002. Conditions in the Spanish, the UK and the US manufacturing labour markets were especially weak.

So basically this is where we get to learn what a global credit crunch means in terms of output and economic growth. Unsurprisingly JP Morgan stress the strength of the slowdown in Spain a number of times.

In fact the Markit Purchasing Managers Index for Spain dropped to 38.3 points in September - the worst reading ever for any European Union country in the entire history of the survey (10 years). The reading was down from the 42.4 one in August. Remember these readings show the rates of month on month contraction. Thus the number may well rise back into the 40s in coming months, but this will still mean continuing contraction in the actual level of output.

Slackening consumer demand - remember retail sales fell year on year by 7.5 percent in August - saw employers lay off workers at a record rate in September, and, of course, unemployment shot up.

A quarter of survey respondents reported lower employment than in August, indicating that the euro zone's worst unemployment rate, 11 percent in July, is certainly destined to get worse. Factories said new business fell substantially and output panellists blamed Spain's sharp economic decline as the main cause of the fastest ever decline in output - the fourth month in the last five showing a record contraction.

The general deterioration of activity in the eurzone - which is now almost certainly in recession - was reflected in a record low reading for export orders.

Services Output Also Declines, But Not As Sharply As Manufacturing

Conditions in the Spanish service sector alos worsened considerably in September. There were substantial declines in activity, new business and employment. Spanish companies were generally highly pessimistic about their prospects over the next twelve months. The seasonally adjusted Markit Business Activity Index, registered 36.1 in September, down from 39.0 in August.

Moreover, the latest fall in activity was the sharpest since the survey was first introduced in August 1999.

Marked falls in activity were reported across all six broad sectors monitored by the survey. The declines were steepest in Transport and Storage and Financial Intermediation. New business contracted at a rate equal to June's series record as customers reduced their activity. The Post and Telecommunications and Transport and Storage areas reported particularly large falls.

As incoming demand weakened, businesses had more time available to concentrate on existing work. Outstanding business declined at the third-steepest pace in the history of the survey. The Other Services sector was the only monitored area to record an increase in work-in-hand.

In response to lower output requirements, businesses sharply reduced their employment in September. Moreover, the decline was the joint steepest since the series began. Job cuts were recorded in five of the six broad sectors, although Other Services saw employment increase strongly.

September price increases cut deep into Spanish service firms' ability to generate profits. Input costs continued to rise quickly, despite the rate of inflation easing for the second successive month. High raw material costs were mainly responsible for the increase. However, companies reported they found themselves increasingly unable to raise charges to customers in response. Furthermore, output prices fell markedly, and at the steepest rate in the history of the series. Weak demand made agreeing increases in output charges with clients difficult. Other Services was the only area able to raise their prices to customers over the month.

Spanish service providers were more pessimistic about the future in September than at any time in the history of the survey, and around one-third of respondents expected lower activity in twelve months' time, with Hotels and Restaurants particularly pessimistic. Reasons for the negative outlook included the ongoing economic slowdown and the asymmetry between input and output prices.

Consumer Confidence Falls Again In September

Spanish consumer confidence fell to its second-lowest ever reading of 49.5 points in September from 51.4 points in August, Spain's Official Credit Institute said on Thurday. The September result was above a record low of 46.3 reached in July. A reading of less than 100 indicates pessimism about the economy based on the index which began in September 2004.

While we are still above July's all time low, and while some of the sub components on the index even perked up a bit in September it is worth remembering that these are small movements around what are, historically, very low levels. The outlook for domestic consumption three to six months from now does not look good. Not at all.

JP Morgan Global Manufacturing PMI Methodology

The Global Report on Manufacturing is compiled by Markit Economics based on the results of surveys covering over 7,500 purchasing executives in 26 countries. Together these countries account for an estimated 83% of global manufacturing output. Questions are asked about real events and are not opinion based. Data are presented in the form of diffusion indices, where an index reading above 50.0 indicates an increase in the variable since the previous month and below 50.0 a decrease.

The countries included are listed below by size of global GDP share, and the figures in brackets are the % og global GDP in each case (World Bank Data).

United States (30.5), Eurozone (18.7), Japan (13.9), Germany (5.6), China (4.9),United Kingdom (4.5), France (4.0), Italy (3.2), Spain(1.9), Brazil (1.9),India (1.7), Australia (1.3), Netherlands (1.1), Russia (0.9), Switzerland (0.7), Turkey (0.7), Austria (0.6), Poland (0.5), Denmark (0.5), South Africa (0.4), Greece (0.4), Israel (0.3), Ireland (0.3), Singapore (0.3), Czech Republic (0.2), New Zealand (0.2), Hungary 0.2.

Disclosure Statement: Edward Hugh is a macroeconomist who maintains a premier set of blogs at Global Economy Matters and is a featured analyst at Emerginvest. Edward Hugh provides non-partisan information about world stock markets, and does not have any holdings in foreign equities. The information stated above should not be construed as investment advice, and Edward Hugh is not liable for any actions taken on said materials.

Monday, October 06, 2008

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

by Edward Hugh: Barcelona

“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.

Friday, October 03, 2008

INSEE Signal Recession In The French Economy

Well, according to the latest estimate from France's national statistics office INSEE, the French economy contracted in Q3 2008, if that is the case I am left asking myself which of the big four eurozone economies could possibly be expected to have expanded in the July to September period. Certainly not the Spanish one, which while not technically in recession yet (you need to consecutive quarters of negative growth to classify as being in recession) can hardly have expanded. The German economy almost certainly contracted, and while the Italian one could sneak a surprise "horses-nose" expansion (given the low level it had reached in the 2nd quarter) I think it is unlikely. So here we go - recession in the eurozone.

France's gross domestic product probably shrank by 0.1 percent in the third quarter after a contraction of 0.3 percent in the three months through June, according to the latest Insee estimate. The economy is also likely to shrink 0.1 percent in the final three months to cut growth to 0.9 percent for the full year, the slowest pace since 1993, Insee added.

``The French economy continues to be hurt,'' Insee's chief forecaster Eric Dubois said at a briefing in Paris yesterday. The current credit crisis ``is an important risk,'' he said, as well as oil prices, ``which have become more volatile.''

French President Nicolas Sarkozy introduced 8 billion euros ($11 billion) of tax cuts this year but this has evidently not been sufficient to underpin French growth as surging commodities prices have pushed inflation higher at the same time as global demand has cooled. Sarkozy this week took additional steps in an attempt to support the economy by allowing the government to buy more than 30,000 unfinished homes at a discount in order to prop up the slumping real estate market. French housing starts were down year on year by 13 percent to 394,726 in the June-August period and the weaker demand has begun to drive down the price of existing homes. Sarkozy is also introducing measures to boost loans to small and medium-sized companies by 22 billion euros ($30.4 billion) by the end of 2009, in a attempt to offset the impact of the credit crunch.

INSEE suggest consumer spending will stagnate in the second half of the year while unemployment rises - to 7.8 percent by the end of the year, up from 7.6 percent in the second quarter, according to their forecast. Corporate investment fell 0.2 percent in the third quarter and may well drop a further 0.1 percent in the last three months of the year. Exports rose 0.1 percent but may drop back by 0.2 percent in Q4, while imports were probably down 0.1 percent in Q3 (reflecting the weakening internal consumption) but could rebound and increase at an equivalent pace in the fourth quarter.

Wednesday, October 01, 2008

Europe's Banks Start To Feel The Strain (Updated)

The euro fell against the dollar yesterday - by the largest amount registered in any single day since the introduction of the single currency in 1999. The drop was effectively a response to the growing signs of strain in Europe's banking sector. Activity in support of banks was widespread throught the day, and across the whole system. The euro fell 2.5 percent to $1.4077 by mid morning in New York, down from $1.4434 on Monday. Early this morning in Europe it was trading in the $1.41 range.

This current pressure on the euro is more the result of signs of liquidity problems in the banking sector than it is a response to the growing weaknesses in the eurozone real economies, which, as we saw at the end of last week, are really pretty substantial in their own right. What follows is simply a summary of some of the highlights of the European banking crisis as it has emerged in recent days. As such it is more a narrative - obtained by scouring the financial press - than an analysis. On the other hand 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, 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 which have their origin in the consequences of the mortgage seize-up for the real economy (rising unemployment, declining bonus payments 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 large 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.

And again, before we proceed, I would stress again that I am a macroeconomist, and not a banking sector analyst. What follows is simply a summary of what I have been able to find out simply reading round the press. As far as I am concerned, getting a measure of what is happening in the banking and financial sector is a necssary preliminary for starting to reach any macroeconomic serious evaluation of what the consequences will be for the real economy. Needless to say, all the 2009 numbers just went down, and they went down considerably. How considerably depends of course on what gets to happen next.

Irish Deposit Support Move

Europe has been restless all week, but on Monday it was really the Irish banks who occupied centre stage, with the Irish government unveiling a wide-ranging guarantee scheme to safeguard deposits and debts at six leading financial institutions. The scheme, which guarantees an estimated €400bn (£315bn, $567bn) of liabilities, covers retail, commercial and inter-bank deposits as well as covered bonds, senior debt and dated subordinated debt.

Most Irish depositors were already covered by an existing deposit insurance scheme for up to €100,000, and the move was essentially aimed at easing short-term funding problem. The scheme offers guarantees for the deposits in Allied Irish Banks, Bank of Ireland, Anglo Irish Bank, Irish Life and Permanent, Irish Nationwide Building Society and the Educational Building Society.

Irish finance minister Brian Lenihan, stated that the government's intention was to make it easier for Irish banks to access funds, and he admitted that "since the collapse of several institutions in the US, it has been very difficult to access funds on international markets for Irish banks.......This will present real problems for the Irish economy if it is not addressed.”

The move followed the biggest one-day fall in bank share prices in two decades. Anglo Irish Bank plunged 45 per cent while Irish Life and Permanent, the Republic’s largest mortgage provider, fell 34 per cent. Allied Irish Banks were down nearly 16 per cent and Bank of Ireland lost 15 per cent. The legislation, which has attracted considerable criticism and triggered inflows of cash into Irish banks from Britain and even further afield (AIB have, for example, outlets in Poland), was unveiled on Tuesday, and passed into law on Thursday.

The Irish economy - like it's Spanish counterpart - had enjoyed pretty spectacular growth since the creation of the eurzone, and was widely know as "the Celtic tiger", even being hailed as a model for the accession states of the European Union to follow (watch out Slovenia). But now the model itself, as well as the advisability of having long periods of ECB serviced negative interest rates, is being hastily re-examined - as construction and property markets seize up in the wake of the global credit crunch. Indeed Ireland last week became the first among the 15 eurozone members to declare it was officially in recession. It may have been the first, but I am sure it won't be the last. The q-o-q GDP data from Ireland has long been volatile
(even when seasonally adjusted) but the y-o-y chart below makes things pretty clear, I think. Not only did the economy contract q-o-q over two consecutive quarters, the contraction also took place vis a vis the equivalent quarters a year earlier. Ouch!

Belgium and France Rescue Dexia

French banks are widely regarded as being the most stable in the current crisis, due to the importance of their retail banking business, and the extent of their deposit base. Nonetheless some French financial entities have been facing difficulties, and on Monday the Belgian and French governments - in a joint initiative - threw a 6.4 billion-euro ($9.2 billion) lifeline to leading local government lender Dexia (which is in effect a transnational entity, based both in Brussels and Paris).

According to the details of the deal reached, the Belgian federal and regional governments and shareholders will invest a combined 3 billion euros into Dexia. The French government will invest 1 billion euros and Caisse des Depots et Consignations, France's state-owned bank, will put in 2 billion euros. The Luxembourg government will buy 376 million euros of notes convertible into shares of Dexia's unit in the country.

Dexia, which employs about 35,000 people in more than 30 countries, generates about half its profit from arranging loans for municipalities from Mexico to Japan, funding infrastructure projects and insuring U.S. municipal bonds. The company also provides financing to half of the France's local governments, according to French Finance Minister Christine Lagarde.

The French Caisse des Depots et Consignations, which is based in Paris, will now become Dexia's largest shareholder with 19.3 percent of the equity, up from 11.9 percent previously. The French government, the Belgian federal government and the Belgian regions will each own a 5.7 percent stake.

Dexia came under pressure following its bailout of Financial Security Assurance, its New York-based bond insurance unit. Dexia agreed in August to provide $300 million to FSA after provisions tied to the subprime crisis led to a loss. The bank had previously pledged a $5 billion credit line to FSA in June, and injected $500 million into the unit in February.

Dexia also took responsibility in August for the $17.3 billion in invested assets at FSA's financial products unit, which includes $7.6 billion of subprime mortgage-backed securities. Dexia's tier 1 capital ratio, which is a measure of it's ability to absorb losses, seems set to rise to something above 14 percent following the capital increase. The ratio currently stands at about 10.5 percent, after suffering 350 million euros in losses related to Lehman's bankruptcy in the third quarter, according to Chief Financial Officer Xavier de Walque.

Fortis Too

Fortis, which is in fact Belgiaum's largest financial-services company, received an 11.2 billion-euro ($16.3 billion) rescue from the Belgian, Dutch and Luxembourg governments (also on Monday) after investor confidence in the bank simply seemed to evaporate last week. Fortis shares had previously dropped 35 percent in Brussels trading on concern the company would struggle to replenish capital depleted by the 24.2 billion-euro takeover of ABN Amro Holding NV units and credit writedowns. Belgium will buy 49 percent of Fortis's Belgian banking unit for 4.7 billion euros, while the Netherlands will pay 4 billion euros for a similar stake in the Dutch banking business. Luxembourg will provide a 2.5 billion-euro loan convertible into 49 percent of Fortis's Luxembourg banking division.

Fortis is the largest European firm to be bailed out so far. Fortis has said it plans to sell its stake in ABN Amro's consumer banking unit, although a buyer has yet to be identified. Fortis joined Royal Bank of Scotland Group and Spain's Banco Santander last year to buy Amsterdam-based ABN Amro for 72 billion euros, just as the U.S. subprime mortgage market collapsed.

Fortis, which was formed in 1990 following the merger of the Dutch insurance company NV Amev, Belgian insurer AG Group and the Dutch bank VSB, has seen its shares fall 71 percent so far this year in Brussels, lowering the market cap to 12.2 billion euros. The company is estimated to have about 3 billion euros of bonds maturing this year and needs to refinance an additional 7 billion euros next year.

Fortis reported a 49 percent decline in second-quarter profit on credit-related writedowns on Aug. 4. The banking business's core Tier I capital ratio, an indicator of a bank's ability to absorb losses, was 7.4 percent at the end of June, compared with Fortis's own target of 6 percent. The company's structured credit portfolio, which includes collateralized debt obligations and U.S. mortgage-backed securities, amounted to 41.7 billion euros at the end of June. Fortis said Aug. 4 the pretax impact of the credit market turmoil on its earnings was 918 million euros in the first half.

And Then There Is Hypo Real Estate

Hypo Real Estate Holding, Germany's second-biggest commercial-property lender, is going to receive a 35 billion-euro ($50 billion) guarantee from the German government and private banks. The bank's rescuers will provide an emergency credit line in two allotments, of about 14 billion euros and 21 billion euros. Private banks will pay 60 percent of the first transfer and the Berlin-based federal government will put up the entire second payment.

Hypo Real Estate said it needs the loan to shield itself from the financial-market turmoil after its Dublin-based Depfa Bank unit ran into problems getting short-term funding. Hypo Real Estate fell as much as 76 percent to 3.30 euros in Frankfurt trading on Monday. At the same time Commerzbank, owner of Germany's biggest commercial-property lender Europhypo, dropped as much as 27 percent.

But Hypo was still fighting for its life on Saturday after German banks and insurers pulled out of a state-led 35 billion euro ($48.5 billion) rescue programme stitched together only days ago. The news is a fresh blow for the global financial system struggling to master an unprecedented crisis of confidence and poses a political challenge for the Berlin government, which has been fighting efforts to arrange a pan-European bank bailout.

"The 35 billion euro rescue package promised to the Hypo Real Estate Group and extending into 2009 announced last week is currently withdrawn," the Munich-based real estate and public-sector lender said in a brief statement.

Hypo Real Estate's financing needs exceeded the bailout plan guarantee, Germany's Die Welt reported yesterday, citing unnamed people in the finance industry. It will need 20 billion euros by the end of next week and 50 billion euros by the end of the year, according to the newspaper. As much as 100 billion euros may be needed to shore up the bank's finances by the end of 2009, Die Welt said.

And Bradford and Bingley

Bradford and Bingley, which is the U.K.'s biggest lender to buy-to-rent landlords, was seized by the British government after the credit crisis shut off funding and competitors refused to buy mortgage loans that customers are struggling to repay. Banco Santander SA, Spain's biggest lender, has agreed to pay 612 million pounds ($1.1 billion) for the building society's 197 branches and 20 billion pounds of deposits.

Bradford and Bingley thus became the second British bank to be nationalised this year - following the rescue of Northern Rock earlier this year.

The U.K. Treasury will take over Bradford and Bingley's 41 billion pounds in mortgage loans. In return, the British government obtains rights to any gains as the bank sells off assets, including personal loans and its Bingley headquarters. UK compensation rules mean other financial entities will have to cover the 14 billion-pound insurance policy the former building society had to protect depositors. A short-term loan from the Bank of England will initially cover the amount falling on the banks.

Santander will pay the additional 4 billion pounds to protect deposits over the 35,000 pound maximum amount covered by the U.K. regulator's compensation plan.

Bradford and Bingley's shares were cancelled in London before the market opened on Monday. The credit crunch had made it impossible to fund Bradford & Bingley's lending. Deposits at the bank were obviously totally insufficent, and amounted to only slightly more than half of loans outstanding. This situation had forced B&B to depend on the now-frozen wholesale capital markets.

``In a nationalization, shareholders get wiped out,'' .........``That's just the risk investors take.''

Bradford and Bingley was the smallest of the four British building societies that transformed themselves from customer-owned lenders to publicly traded mortgage specialists during Britain's housing market boom. It was created in the 1964 merger of the Bradford Equitable Building Society and the Bingley Building Society, both established in 1851. The combined company started to sell shares on the London Stock Exchange in December 2000 and had a market value of 3.2 billion pounds as recently as March 2006. Shares plunged 93 percent this year, to reach 20 pence on Sept. 26, reducing Bradford and Bingley's market value to a mere 289 million pounds, even following the raising of 400 million pounds in its third attempt to replenish capital.

Basically the UK's falling home prices and rising unemployment took their toll, and pushed up late mortgage payments to more than 2 percent of B&B's loans. That compares with the U.K. average of 0.5 percent, according to the UK Council of Mortgage Lenders. Almost half of B & B's 42 billion pounds in loans went to landlords, bringing its share of the U.K. buy-to-let market to 19 percent. Arrears on loans to buyers who rent out their properties rose from 0.73 percent at the end of 2007 to 1.1 percent by June 30, according to the council.

About 17 percent of the bank's loans went to customers whose incomes weren't verified, and obviously such lending typically has a higher level of default than loans to standard borrowers. B & B's bad debts in the first half jumped to 74.6 million pounds from 5.3 million pounds last year.

U.K. government and BoE officials had tried for most of the year to prevent B & B from becoming the second Northern Rock, and had earlier borrowed about 24 billion pounds in emergency funds from the Bank of England.

Northern Rock was nationalized in February and got an additional 3.4 billion pounds from the government last month after late loan payments rose to 1.2 percent amid the U.K.'s steepest decline in house prices since 1992. The U.K. has so far managed to avoid nationalization of HBOS, the UK's biggest mortgage lender. It waived antitrust restrictions on Sept. 18 to allow Lloyds TSB Group, the U.K.'s largest provider of checking accounts, to enter into negotiations to buy HBOS in a stock swap valued at about 12 billion pounds. But this deal has yet to be cobcluded, and yesterday shares in HBOS fell as much as 20 percent amid market chatter that Lloyds could reduce its offer by a quarter.

Lloyds shares were up 3.9 percent in mid afternoon yesterday, giving its bid a value of 187.4 pence under the recommended offer which will see HBOS investors get 0.83 Lloyds shares for every HBOS share they own. By contrast HBOS shares were down 10 percent at 127.8 pence, making them the biggest faller in the FTSE 100 share index and putting them at a 31 percent discount to Lloyds' offer price. The stock had earlier fallen as low as 113 pence. Rumourology had it that on nthe back of the change in relative values Lloyds could revise its offer to 0.6 of a TSB shares for each HBOS share.

HBOS, is another bank which is dependent on wholesale borrowing for its mortgage funding, a gets almost half of its funding from this source. HBOS has seen its share price fall 86 percent since the onset of the credit crunch in September last year. HBOS' loans are estimated to have 52 percent cover from customer deposits, against 61percent for Lloyds and 55 percent for the combined group.

If the deal goes through it will create a lender with a 28 percent share of the UK mortgage market and the new entity will control a quarter of the country's current or checking accounts.

Italy's Unicredit

Attention today has shifted to some extent to Italy, where UniCredit SpA, Italy's biggest bank and owner of Germany's HVB Group, has fallen more than 24 percent in three days as the feeling has grown that the bank may need to raise money to strengthen its finances. Concern that UniCredit may help in the bailout of Germany's Hypo Real Estate Holding, a development which could have negative consequences for Unicredit's capital position seems to be behind the fall. Hypo Real Estate was in fact spun off from HVB Group in 2003.

UniCredit announced its intention of "spinning-off" real-estate assets to boost its core Tier I capital ratio to a target of 6.2 percent by the end of the year. The property spinoff and unspecified transactions the bank carried out last month will raise the core Tier I ratio by 0.27 of a percentage point, according to today's statement. UniCredit didn't give further details about the location or extent of the real-estate holdings.

UniCredit has made $61 billion of acquisitions during the past three years, including buying Capitalia SpA last year and Munich-based HVB in 2005. Munich-based Hypo Real Estate was founded when HVB spun off its commercial real estate business in October 2003 to boost its capital ratio and protect its credit ratings after an 829 million-euro loss in 2002. HVB's core capital ratio stood at 15.2 percent at the end of June, based on Basel II accounting standards.

UniCredit later rebounded in Milan trading after the Italian stock market regulator banned short sales of banking and insurance stocks and Prime Minister Silvio Berlusconi said he "wouldn't permit" speculative attacks on banks. UniCredit shares jumped 29 cents, or 11 percent, to 2.89 euros on the news that short selling was to be banned, after falling in earlier trading to the lowest since December 1997. The stock is down 49 percent this year, giving the company a market value of about 38.6 billion euros ($54 billion).

Unicredit is also exposed due to the extent of its lending in Eastern Europe - which are estimated to amount to one quarter of its total operations. According to the Spanish newspaper Expansion Banco Santander are interesting in acquiring this part of Unicredit's operations.

UniCredit shares plummeted 24 percent during the first three days of last week. The stock then recovered some of the losses after Italy's stock-market regulator on Oct. 1 banned short sales of banking and insurance stocks, and Prime Minister Silvio Berlusconi said he ``won't permit speculative attacks'' on banks.

Consob, Italy's market watchdog, may have uncovered a case of short selling of UniCredit shares borrowed and sold on Sept. 30 and not delivered back to the lender as of yesterday's deadline, Ansa reported, without citing anyone. Italy's finance police are investigating the whereabouts of 60 million UniCredit shares valued at about 180 million euros, Ansa said.

In terms of lending against deposits, Unicredit's current ratio is 97 percent for 2008, below Intesa Sanpaolo's 104 percent. Both the Italian majors have LtD ratios below the European bank average which is estimated to stand at about 129 percent. Credit-default swaps on UniCredit rose 26 basis points to 150 at 4:40 p.m. in London, according to CMA prices.

The curious thing is that Unicredit is involved in some way or another in the Hypo Real Estate Affair via its ownership of the German bank HVB. All of this is very curious, since Unicredit seems very exposed across all of Eastern Europe via this channel, and it's ownership of Bank Austria Creditanstalt. Unicredit is also exposed in the Baltics, since on September 1, 2007 ASUniCredit Bank Estonian Branch took over the business of HVB Bank Tallinn Branch.

Starting from January 10, 2007, Bank Austria Creditanstalt (BA-CA), the Vienna-based center for CEE business of UniCredit Group, had become a sole shareholder of HVB Bank Tallinn Branch, acquiring 100 % direct substantial interest in the Baltic bank by the German Bayerische Hypo- und Vereinsbank AG.

It is interesting also to note that Unicredit is holding an exceptional board meeting on Sunday to discuss a plan to boost its regulatory capital and settle investors' concern with its financial position. The bank is reported to be considering paying its dividend in shares so that it can hold on to about 3 billion euros ($4.1 billion) in cash and bolster its Core Tier 1 capital ratio, but in this climate it is not clear how the markets will respond to this type of weakness.

Fitch Ratings has Thursday changed the Outlook on UniCredit to Negative from Positive. Fitch has also changed the Outlook on UC's subsidiaries - Germany-based Bayerische Hypo- und Vereinsbank AG (HVB) and Austria-based Bank Austria Creditanstalt AG - to Negative from Positive. Furthermore, the rapidly changing operating environment, the dull macroeconomic prospects in Italy and Germany and the less benign outlook for some central and eastern European markets might result in further loan impairment charges. 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; internal capital generation is weakening and there are no plans to strengthen capital significantly in the near future. Meanwhile, conditions in the wholesale funding market remain extremely challenging.

Europe Wide Response?

So what now? Well, as much of the press seems to be noting, all that "NINJA mortgage ha ha ha" stuff from the EU politicians is now starting to look pretty silly (Peer Steinbrueck may well have been the worst case scenario here - being actively seen to gloat with his "ninja loans" quip - short for "no income, no job, (and no) assets." - but I think before anyone laughs too loudly we should just wait and see what happens to the German economy if the run on the Russian financial system continues). Europe's leaders have really been extremely foolhardy in giving the impression to their electorates that the European economy was completely sound and that Europe's banks would avoid any fallout from the global housing bust. If a whole generation of new financial products are suddenly withdrawn from the market (rather like all that "tainted" Chinese milk) it should be obvious that property prices and the construction industry everywhere will feel something, and those banks who didn't have a local property boom to fund, well they simply got involved in buying securities issued by others who did, via the so called "global wholesale money markets".To take just one simple example - of the estimated $591 billion in losses and writedowns so far recorded by global banks since the start of 2007, 39 percent have been accounted for by European institutions.

Yet despite all of this, some European politicians are still at it. Italian Prime Minister Silvio Berlusconi was busying himself yesterday trying to vaunt it over the United States for just this sort of reason. While Italy's financial stability panel, which met for the third time in 10 days yesterday, discretely limited itself to saying what it was supposed to say - namely that the impact of the global financial crisis on Italy's banking and insurance system remains limited and Italian banks had enough liquidity - Berlusconi was busy proclaiming that Italy was far better placed to handle its problems than the United States was: "I am not pessimistic about the future ..." he is quoted as saying "because our financial situation is less fragile than that of the United States,". This, I think remains to be seen, and such bravado in making comparisons hardly befits a Prime Minister whose country has just enetered its fourth recession in eight years and which looks set to contract across whole year 2008.

And the President of Spain's government, José Luis Rodriguez Zapatero, doesn't seem to be much better, since he seized the opportunity provided by his recent United States trip to tell a group of businessmen that the Spanish financial system, unlike its US counterpart, was in extremely good health. Not satisfied with simply making himself look ridiculous, he went further, stating that the extent of Spain's growth had depressed Silvio Berlusconi (his traditional "enemy"), and even suggested that Spain would overtake France in terms of per capita income within three or four years. If someone else hadn't used the phrase already this week, I would have said that what we had here was a clear case of "whom the gods would destroy they first make mad", as it is I will simply have to limit myself to saying that the condition of the patient with Artemio Cruz Syndrome is evidently detiorating.

What Can The EU Do?

However, recognising that we will need some sort of concerted intervention to address the developing problem is one thing, and deciding what that intervention should be is quite another (as we can see from what is happening in the United States right now, getting consensus on any sort of major intervention is far from easy). 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. 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.

"Europe gives up on a joint rescue plan against the crisis," wrote the
centre-left El Pais, lamenting that the EU "lacks the necessary institutions to
respond as the United States has done. Although the crisis has hit the US harder so far, "in the EU even a minor crisis could be more devastating because of the lack of an institutional framework and political will.""

US NBER 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 drawing on surpluses in another. Feldstein was thinking about asymetric recessionary processes, and I doubt was thinking about a problem of the severity of the one we now face at the time, but in the longer run he has been proved right, this sort of problem was always going to arise at some point or another.

And we also need to think about the budget deficits issue. If certain of the 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 soverign rating ones.

At the present time the European Commission seems to be limiting itself to talking about regulatory issues for the future, and new legislation proposals are expected later this week aimed at strengthening bank monitoring across borders, but such moves will hardly serve to resolve the present issue. Up to now European governments seem to have only agreed to a concerted supervision framework which is set to come into effect in 2012, pledging themselves to cooperate as required in managing any crisis, but they have most meticulously resisted devising any kind of formula for splitting the bill in the event that a cross-border bailout should become necessary, or that the problems of one country (and Spain immediately comes to mind here) should become to great for any single member to handle alone.

Daniel Gros, director of the Centre for European Policy Studies in Brussels, in particular has come out and stated that European governments ultimately will have to put capital into their banks, which he calculates are more leveraged than their U.S. rivals.

``These are highly leveraged institutions which need to have support from the public purse,'' according to Gros.

Daniel Gros also suggested that EU governments assign the European Investment Bank, the EU's financial arm, the job of infusing 250 billion euros to support the region's banks, in return for an equity stake. The quantity he mentions seems rather small by my calculations (I think more than this will be needed in Spain alone), but he is undoubtedly scratching around in the right area.

There is, however, considerable doubt about whether a significant package can be put together. Sarkozy appears to have already retreated from the original French initiative. While the Netherlands yesterday called on states to set aside funds to help troubled banks, Germany opposed a joint approach to the crisis. The four European members of the Group of Eight nations meet over the weekend in Paris to talk about the credit crisis.

Controversy is already extensive following the Irish decision to guarantee deposits, and now Greece has followed suit, meaning that two of the three eurozone countries have now taken the move, in the process leaving the third country, Spain, rather alone and rather exposed. Greece's government have decided to guarantee all bank deposits in the country, according to a senior finance ministry official yesterday.

Greece's cabinet had met to discuss ways to insulate the country's financial system from the global crisis, amid media reports that worried savers were withdrawing savings from banks. The value of deposits in the Greek financial system at around 230billion euros - roughly equivalent to Greece's annual gross domestic product.

The measure now needs approval from Greece's 300-seat parliament, but opposition to this move is hardly likely, given the popularity which will go with the measure.

European banks are seeing depositors withdraw their cash and savings and moving them to countries which enjoy full government protection for banks, the Wall Street Journal reported today, citing the findings of financial analysts. Ireland's announcement that it would fully guarantee deposits in its retail banks triggered a steady stream of cash from U.K. banks, where the government guarantees only cover a limited amount; as we have seen Greece has already followed the Irish model. An analysis by analysts 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. The U.K.'s bank regulator yesterday - the Financial Services Authority - on Friday responded to the problem created by the Irish decision by increasing its insurance ceiling to 50,000 pounds ($88,500) per account from 35,000 pounds to stem a flow of funds to Ireland.

Strange anomalies are also being uncovered, since Britain's Post Office, whose savings products are backed by the Bank of Ireland, has also reported a rise in the number of customers seeking to invest, while earlier this week, Northern Rock - whose savings are guaranteed by the British government after the February nationalisation - desided to limit some of its savings accounts after cash flowed in, prompting rivals to complain it was distorting competition.

Money-market rates jumped to records, Treasury bill rates fell and the Bank of England relaxed borrowing rules for financial institutions as ``extraordinary'' strains deepened the credit freeze.

The London interbank offered rate, or Libor, that banks charge each other for three-month loans in euros increased to 5.33 percent, an all-time high, the British Bankers' Association said. The corresponding rate for dollars climbed to 4.33 percent, the highest since January. The Libor-OIS spread, a gauge of cash scarcity among banks, widened to a record and Asian bank rates climbed to the highest levels in at least nine months.

The Libor-OIS spread, the difference between the three-month dollar rate and the overnight indexed swap rate, climbed 20 basis points to 290 basis points today. It's the third consecutive day the spread has risen to an all-time high. The average was 8 basis points in the 12 months to July 31, 2007, before the credit squeeze began.

Rates on three-month US Treasury bills declined for a third day, dropping 11 basis points to 0.49 percent. They touched 0.02 percent on Sept. 17, the lowest since the start of World War II. The difference between what US banks and the U.S. Treasury pay to borrow money for three months, the so-called TED spread, was at 386 basis points today. The spread was 113 basis points a month ago.

European Central Bank Executive Board member Lorenzo Bini Smaghi is quoted today as saying that European countries should coordinate their efforts to safeguard the financial system by buying stakes in struggling banks. "In Europe, the intervention must be coordinated in order to avoid unequal treatment" Bini Smaghi wrote in a letter in Italy's Corriere della Sera newspaper. Rather than buy a bank's bad assets "It's better to step in on the capital side, as was done in the case of the Belgian bank Fortis last weekend.'' This could also be read as an implicit criticism of the recent "go it alone" on the part of the Irish government in guaranteeing both loans and deposits for the Irish banks.

The French proposal for a European Union-wide bail-out scheme - outlined by French Finance Minister Christine Lagarde in an Oct. 1 interview with the German newspaper Handelsblatt -would seem at first sight to be an audacious bid to seize the political initiative before the crisis depens too far. But his proposals are likely to be met by a chorus of criticism from some quarters - especially from Germany. "The idea of applying one solution, one big bang'' to the crisis "is not practicable and would create new, enormous problems,'' German Finance Ministry spokesman Torsten Albig is quoted as saying. "The tailor-made solution is the right way,'' he said. In fact the Irish government seem to share the German view since Martin Mansergh, an official in the finance department, rejected Brown's criticism and said ``national governments have the primary role in resolving the crisis'' and not ``grand European solutions.'' The Greek government would undoubtedly agree, but I am not sure this view will be shared in Madrid, since Spanish banks are likely to be the long term casualty of the two junior countries effectively dropping out of the race to the bottom.

Although Sarkozy initially appeared to support the plan and seemed willling to stand firm in the face of its numerous critics - stressing that what he wanted was an open-minded debate, “putting aside dogma” - he now seems to have backed off. Initially there was even a number - €300bn - put to the cost of EU bank rescue, but under continuing pressure he has reterated and even go so far as saying “I deny the sum and the principle (of the rescue scheme).” In general French officials are now at some pains to stress that the plan which was mentioned by Lagarde was a Dutch one and not French at all.

Sarkozy had, it seems, hoped to forge a common front at a summit with his German, British and Italian counterparts in Paris on Saturday, but the furore – led by the German government – over the bail-out fund proposal has stopped him in his tracks. The summit is now likely to focus on the existing efforts to tighten regulation of ratings agencies and improve co-ordination between supervisors, and a review of mark-to-market accounting rules. One possible face-saving initiative could be to agree on common standards for bank deposit insurance. EU officials believe that harmonising the protection for savers would discourage other member states from following Ireland and offering blanket guarantees to banks. Greece on Thursday became the latest EU country to propose more protection for savers.

Jean-Claude Trichet, on the other hand, underlined the fact the EU’s structure was is not designed to accommodate a common bail-out scheme. “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,” he is quoted as saying.

In fact Trichet hasn't always argued this way, back in July he made the explicit comparison with the US Federal reserve, and the fact that it runs an interest rate policy geered to serve all 50 states covered by the Federal system.

``If you concentrate on California or Florida, it is not at all like Massachusetts or Alaska,'' he said in an interview with Ireland's RTE radio at the time of the rate increase to 4.25%. "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. But now the US Treasury is not concentrating on the needs of Florida or Massachusetts, but on 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.

Silvio Berlusconi may well want to be seen supporting the Sarkozy proposals for greater regulation, but with the desperate state of Italy’s public finances – debts of more than 103 per cent of gross domestic product – he will not be in a position to offer much in terms of an EU bail-out package. However, the Dutch government said it would continue to press its idea for a €300bn ($415bn, £235bn) scheme whereby each of the EU’s 27 member states would set up its own rescue fund worth up to 3 per cent of gross domestic product. Meanwhile, Spain, Belgium and other EU countries that are not invited to Saturday’s meeting, have warned Sarkozy and his British, Italian and German guests that they will have no authority to take decisions on behalf of the 27-nation bloc as a whole.

And this seems to have been the approach adopted at the Saturday meeting. France, Germany, Britain and Italy put on a united front, promising a more coordinated approach to the credit crunch, although Germany's Chancellor Angela Merkel insisted states would mainly act individually. President Nicolas Sarkozy, did not dispute this point, but said a new "doctrine" had been agreed. Sarkozy said the four had agreed to punish failing bank executives and to call for a rapid meeting of the Group of Eight world industrialised powers to marshall a global response to the financial crisis.

"We have agreed to make a solemn engagement as heads of state and government to support banking and financial institutions faced with the crisis," Sarkozy said at a joint news conference following the three-hour meeting. "Each government will operate with its own methods and means, but in a coordinated manner. In a way, we have devised a doctrine," he added. Brown agreed: "Where action has to be taken we will continue to do whatever is necessary to preserve the stability of the financial system."...."The message to families and businesses is that, as our central banks are already doing, liquidity will be assured in order to preserve confidence and stability," he promised.