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July 31, 2020

Why we have been so pessimistic, and what will need to happen to change that

We are acutely aware that our take on the future of the eurozone is radically different from that of many other commentators. As this is our last briefing before the holidays, we thought we would lay out in some detail what’s behind our thinking and the analytical method through which we assess policy. That method is not foolproof. We had our share of errors. But the method as a whole served us well in the last 13 years by helping us remain focused on the essential, and not to fall for PR coups made in Brussels.

Our concern is the sustainability of the monetary union and the eurozone’s long-term prosperity. We concluded a long time ago that a monetary union with a single monetary policy but only minimal fiscal coordination and structural convergence mechanisms cannot last. It may in theory, but not in practice. That in itself does not constitute a prediction of the eurozone’s demise, merely a conditional statement that the persistent lack of such policies would cause that calamity to happen eventually.

The story is not binary. Sustainability has a technical component we believe is largely solved. The combination of the ECB’s new monetary policy instruments and the creation of the European stability mechanism have succeeded in addressing one particular threat: death by speculative attack. To the extent the EU achieved real progress, this is where it happened.

But sustainability has other components as well. Persistent economic divergence could persuade countries on either end of the eurozone’s productivity scale to leave the monetary union in hopes of achieving a better macroeconomic policy framework for themselves. Greece had a fling with Grexit in the spring 2015. The Five Star-Lega coalition in Italy had plans for a parallel currency. There was a whiff of Nexit in recent discussions in the Netherlands. Most of us would probably agree that a convergent monetary union would be more stable in the long run than a divergent one. When the EU created the monetary union, it only recognised nominal convergence criteria as conditions for joining. This was based on the prevailing economic orthodoxy at the time. But the divergence that took place subsequently was not in inflation but in productivity and employment. There are no effective EU-level instruments that could do the heavily lifting on reforms in those areas.

Our focus on the eurozone’s sustainability also means that we disregard very common arguments, like the following:

  • the recovery fund is the EU Hamiltonian moment because the EU accepts, for the first time, the principle of a fiscal transfer; 
  • nobody would have thought in their wildest dreams that the EU would go as far as it did;
  • let bygones be bygones, Angela Merkel has secured her place in history by placing Germany outside the camp if the frugals.

One can make plausible arguments in favour of each of those statements. We do not regard them as true or untrue, but as irrelevant. And yes, that includes Merkel’s position shift. We recognise it as a symbolic moment, but unlikely to have much of an effect on Italy’s future in the eurozone. Italy’s sustainability in the eurozone will not be determined by any of this.

Doubts over sustainability are not a single person’s or a single country’s fault. We see nothing in the recovery fund, including the applied conditionality, to address Italy’s debt sustainability problem. The fiscal transfer that is inherent in the programme is not big enough to make a dent in it. And it is would naive to think that the ECB will support Italy forever. There will come a day when central bank purchases of italian bonds end, and holdings are wound down. 

So, rather than focusing on the long list of things that won’t do the job, let us now focus on those that might.

  • A eurozone-wide fiscal space backed by a significant increase in the EU’s own resources. The fiscal union does not have to be large. We think 5% of GDP is sufficient. But it must be large enough for the eurozone to use its own financial balance sheet as a policy instrument. It cannot do this with a €390bn grant.
  • Europeanisation of structural policies, including labour markets, pensions, and regulation of services and industry. This is essential to ensure that the eurozone is not just a single market, but a single economy. This means economic divergence takes place where it should: between regions, towns, companies and individuals, not between states.
  • An obligation on policymakers to strive for a high degree of economic balance over long periods, and that forces them to act if imbalances become persistent.
  • Agreement that the euro is a geopolitical instrument that can and should be used in support of the EU’s geopolitical goals.

This is not intended as an exhaustive list, merely a sketch of the scale of things needed to render a monetary union of divergent and sovereign countries sustainable, and to stop it from limping from crisis to crisis. The global financial crisis left the euro’s banks and some governments weakened. So did the eurozone crisis. And so will this one. We will judge a set of policies successful if we have reason to believe that this doom loop is broken.

If you think that none of this is realistic, you owe us an explanation of what steps you think are necessary for a lasting monetary union, or whether you are prepared to accept a break-up. Remember, the unsustainable does not become sustainable because somebody has done more than others thought they would, or because someone gave a wonderful speech. When we return from our summer break, we promise to continue to look at the eurozone with our analytical polaroid filter, one that cuts through reflections and mirages. 

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July 31, 2020

Insurers and a few large banks are most exposed to leveraged loans

Right now default rates in leveraged loans remain historically low, but there are signs of distress in the market, driven to some extent by government loan guarantees during the pandemic. The crisis will have a big impact on the revenue, liquidity, and ultimately solvency of many companies. This is the kind of shock that could cause a generalised crisis in speculative segments of the credit market. 

The exposure of the EU financial system to leveraged credit is low on average, but there are concentrated exposures in large banks and amongst asset managers. 

The European Banking Authority has just released an analysis of the exposure of the EU financial system to leveraged credit. The most striking conclusion is that the exposure is concentrated in a few large and highly-interconnected banks, for which it is a significant fraction of capital at risk. European banks are mostly exposed to leveraged loans, much more than to high-yield bonds or collateralised loan obligations. CLO are synthetic bonds made from leveraged loans. Insurers and money managers are more likely to be exposed to bonds and CLO. 

Readers may recall leveraged loans have been a focus of our coverage in recent years as the segment grew to be larger than the junk bond market. About three-fifths of the global leveraged loan segment is in the US, and one fifth in Europe. The IMF puts the outstanding leveraged loans in Europe at €1tn. Issuance peaked in 2017, but it was still over €160bn a year in Europe in 2019. CLO issuance has virtually stopped since the lockdowns. 

Bank exposures to leveraged finance are small on average, just 2.5% of total assets. But this is over 10% of the credit exposure to non-financial corporations, and nearly 50% of banks' core equity tier 1 capital. The average is misleading, however. The EBA points out the exposure to leveraged finance is concentrated in a few large and highly interconnected banks where they account for a larger share of assets. Exposures could be even higher due to inconsistencies in the way international data is gathered, and also if one takes into account revolving credit to leveraged borrowers, as well as credit lines with asset managers. If the Covid-19 crisis impairs credit further, loans not initially classified as leveraged may become reclassified, as a result of borrowers increasing their debt or being downgraded by rating agencies. Banks are also being saddled with loans they intended to offload into CLO, but have not been able to due to the stop in CLO issuance.

The EBA observes that the default rates on leveraged loans remains very low, about 2% in the US and even lower in Europe. There are a couple of reasons for the low default rate in the face of high distress. One is the maturity structure: less than 10% of the loans mature this year, and about half mature after 2023. Many of these loans have relatively small periodic payments and most of the interest is paid at maturity. The other reason is the expansion of so-called covenant-light loans, with relatively weak creditor protections. This means that distressed loans that would otherwise be in default are not being recognised as such. So, the weakness in the leveraged credit segment manifests itself in the secondary market for loans and in leveraged loan securitisations.

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July 31, 2020

What the German GDP numbers are telling us

There is no question that the economic impact of the Covid-19 lockdown was strongest for economies with a strong tourism sector, like Spain or Italy. The latest UK quarantine has essentially killed this year’s summer season in Spain for British tourists. Barring a new virus wave, however, the tourist seasons of southern Europe will have returned to normal by next summer. German industry, by contrast, will then still be limping.

Yesterday’s news of a 10.1% decline in German Q2 GDP is not particularly horrendous by international comparison. It is a bit worse than the US but better than the rest of the eurozone. The shock was that everybody expected a better number. We wrote previously about the complacent forecast by the Council of Economic Advisers, who originally predict a Q2 fall in GDP of 4.5% as a result of the lockdown. They misjudged exports. We are reminded of similar ignorance during the eurozone crisis, when modellers underestimated the effect of what happens when everybody cuts their fiscal spending at the same time. This year, the modellers misjudged the complex global network effects of almost-coordinated lockdowns. Going forward, they would have to assess the dual impact of unprecedented sectoral shifts in consumption and a hard-to-calculate pace of repair of global supply chains. It is probably best in such a situation to look at some of the hard industrial data. As we reported two days ago, German industry is struggling to recover. 

German industrial production was up by 7.8% in May over April, but still 20% down on the year before. The German federation of industry, not usually prone to pessimism, predict it will take industry another two years until mid-2022 to reach the pre-crisis level of production. This charts below gives the scale of what’s going on. Blue is industry and red is construction.

Note, the red line is construction, and blue is industry. Our expectation is that the level of industrial production is unlikely to recover in full, as there are structural shifts in global supply chains and global trade policy that will encourage some companies to relocate production. We have big shifts going on in the car sector. Even before the Covid-19 lockdown, the German car-component suppliers were already planning big layoffs, to be followed by the car companies themselves. What the lockdown may have achieved is to accelerate that shift.

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July 31, 2020

Macron the reformer - revisited

Emmanuel Macron came to power as a reformer who delivers what he promises. But after the gilets jaunes and the pandemic, the French president changed tack with a new prime minister, Jean Castex. The tone and image of the executive changed in no time, while the political imprint became vague. Castex wants to listen and reassure, but can he still reform with the consent of the people? Does this new apprehensive approach not condemn politics to immobility? In times of heightened economic uncertainty, pushing through reforms seems high-risk, so the focus is on stimulus instead. But not to deliver on reform promises also risks alienating Macron's core voters. This is all about the electorate Macron aims to reach in his 2022 re-election campaign.

There is a clear shift when it comes to reforms. One of the first acts by Castex was to prioritise dialogue with the trade unions and postpone the pension and unemployment insurance reform. The abolition of the housing tax for the wealthiest 20% of households has been moved to 2023, that is after the presidential elections. Abandoned is also the reform of the institutions, one of Macron's campaign promises. The government blames the senate for blocking it. So, what remains of Macron the reformer, wonders Le Monde? This is the heart of the French ambiguity of wanting to see reforms but at the same time be reassured.

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July 31, 2020

Divide et impera - Turkish edition

Turkey/EU relations are entering a new phase. After the military posturing in the Aegean, it is now time to talk. But don't be fooled, Turkey suspended its gas exploitation survey near the Greek islands only for one month, as Spain’s Foreign Minister found out on her visit to Ankara. At the same time, Turkey is pursuing its oil search off the shores of Cyprus. Two EU countries, two different strategies.

For Ankara there is much to be gained by dealing with European countries separately. The EU may threaten sanctions, but member countries are hopelessly divided. The attempt by Greece with French backing to push sanctions firmly on the table failed in the latest EU foreign-affairs council meeting of July 15. If Turkey continues its charm offensive with some selected member states, it may be enough to keep the prospect of sanctions in check. At the same time, Turkey just needs to threaten a hot incident in the Aegean to increase its stakes in the negotiations. Turkey has no interest in a military confrontation with Greece. The country has enough going on in Syria and Libya. But to show that it is ready to pursue what it considers to be its right will be a useful card for Ankara to play when the two countries coming together at the negotiation table. 

Berlin is to facilitate talks between Turkey and Greece over the delineation of maritime borders. This is where the tricky part starts. Turkey's negotiator, Ibrahim Kalin, told CNN that Turkey is ready for bilateral talks without preconditions on the Aegean, continental shelves, islands, air space, exploration and the Eastern Mediterranean. But what does this mean? Turkey has accused Greece of trying to exclude it from the benefits of potential oil and gas finds in the Aegean Sea and Eastern Mediterranean. The country argues that sea boundaries for commercial exploitation should be divided between the Greek and Turkish areas and these should not include Greek islands on an equal basis, writes Macropolis. Athens argues that this would be a violation of international law. A legal clarification by an international court would take more than one month to sort out though. In the meantime, a political solution would be the only way forward. 

Turkey is unlikely to backtrack on its claims completely, even less so when it comes to Cyprus. In this case Turkey is also defending the rights of the Turkish Cypriots. Kalin insisted that both sides in Cyprus should seek common projects and share revenues if something is found. 

How far are all sides willing to compromise? They may all be looking at a face-saving way out of this standoff. Al Monitor writes one way to look at this is to get realistic about the potential revenue from energy developments. The EastMed pipeline project was to bring oil and gas via Greece and Cyrus with the consent of Israel. At the moment, though it is commercially not viable unless more resources are found. But politically this could serve as a token in the geopolitical poker game.

The clock is ticking. There will be an informal meeting of EU foreign ministers on August 27-28, possibly focusing on Turkey. Ankara clearly wants to negotiate and Europe has an interest to find a face-saving way out of this. If they can negotiate something other than sanctions or the pursuit of oil searches in Greek and Cypriot waters, we will know it by then.

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July 31, 2020

Erdogan is doing battle with macroeconomics, too

Recep Tayyip Erdogan is doing battle on many fronts: occupying a strip of Syria, waging a proxy war in Libya, and with aggressive diplomatic and economic moves in the waters of the eastern Mediterranean. But lately Turkey is also in battle with the financial markets. While sometimes in the geopolitical contest it may be possible to succeed by sheer force of will or brazen diplomacy, we wonder whether the same is possible against the forces of macroeconomics. While it is true that a country can run unsustainable fiscal and external deficits for a long time, this cannot be done indefinitely and especially if one is trying to do it in dollars, too. It is an open question whether and how Turkey's market troubles will interact with the geopolitical situation.

Since the pandemic hit, the Turkish lira's exchange rate has deteriorated, and the central bank has attempted to stabilise it around 7 liras to the dollar for the past two months. But the effort seems to be faltering and the currency has begun dropping again this week. Reasons cited by analysts include the effect of the pandemic on tourism, and the threat of EU economic sanctions. Even without sanctions, it can be enough if investors are spooked by their prospect.

Turkey had a brush with a balance of payments crisis in 2018, as global trade slowed down and Erdogan got himself into a diplomatic spat with Donald Trump. The currency dropped and the central bank reacted by hiking interest rates above 20%. Then last year the global trade slump let up somewhat, and Turkey took advantage of tourism revenue to improve its balance of payments. Erdogan also replaced the finance minister with a crony and put political pressure on the central bank to keep interest rates low and fuel a credit boom. Essentially, Turkey is trying to do the impossible by keeping a stable interest rate, open capital flows, and low interest rates. Covid-19 has reduced the flow of income from foreign tourism, while the relatively mild outbreak in the country has kept up demand and therefore imports. 

According to Bloomberg, the country is expected to widen its current account deficit to 2% of GDP this year, and its fiscal deficit to nearly 7%. Meanwhile, currency reserves have dropped by 40% since the start of the year, and by about one-sixth if one includes gold. The Turkish central bank has propped up its reserves by borrowing dollars from domestic banks, which hold residents' foreign-currency deposits, and through currency swaps with countries such as Qatar, so the situation may be a bit more serious than the headline reserve figures show. Given the figures being reported, one may wonder whether Turkey can keep up its battle with the currency markets for the rest of the year. 

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