Europe's lost decade as $7 trillion loan crunch looms

Europe’s banks face a $7 trillion lending contraction to bring their balance sheets in line with the US and Japan, threatening to trap the region in a credit crunch and chronic depression for a decade.

By Ambrose Evans-Pritchard

8:30PM BST 16 Oct 2011

the Telegraph

The risk is "Japanisation" without the benefits of Japan: without a single government, or a trade super-surplus, or 1pc debt costs, or unique social cohesion.

Even today, the jobless rate for youth is near 10pc in Japan. It is already 46pc in Spain, 43pc in Greece, 32pc in Ireland, and 27pc in Italy. We will discover over time what yet more debt deleveraging will do to these societies.

Stephen Jen from SLJ Macro Partners says the loan to deposit (LTD) ratio of Europe’s lenders is 1.2, much like Japanese banks in the early 1990s at the onset of the country’s Lost Decade (now two decades).

How Europe allowed this to happen will no doubt be the subject of many enquiries. Suffice to say that it was an intellectual failure by everybody: lenders, economists, regulators and the European Central Bank. The ECB misread the implications of the global capital surplus in the middle of the last decade (like the Fed) and gunned the M3 money supply at double-digit rates (like the Fed).

This great error further juiced the fatal flood of lending from North Europe to Club Med. Interestingly, it is what US lending did to Germany in the late 1920s. When the music stopped -- when Wall Street cut off loans, as Germany has now cut off loans to Spain -- trouble ensured within two years. Weimar limped on, but not for long.

The Japanese eventually trimmed their LTD ratio to the current safe level of 0.7pc, the same as US banks. It is a fair bet that new bank rules and market pressure will force Europe to do likewise. Mr Jen said this means slashing the loan book from $19 trillion to nearer $12 trillion, given the dearth of fresh deposits.

It will be an ice-cold douche for the world. European banks have $3.4 trillion of cross-border loans to emerging markets (BIS data), three-quarters of the total. They account for 46pc in Asia, 63pc in Latin America, and 90pc in Eastern Europe.

Either these banks will cut funding to Eastern Europe, or they will curtail loans at home. Most likely they will do both. Mr Jen said a lot of nasty "feedback loops" will blight the whole European region for a long time.

The sheer scale of Europe’s bank excesses -- roughly equal to Alan Greenspan’s household bubble in America -- shows what EU leaders are up against as they thrash out their latest "Grand Plan" to save Euroland.

Angela Merkel and Nicolas Sarkozy have bowed to pressure from Washington and the International Monetary Fund for bank recapitalizations, by compulsion if necessary. Lenders must raise core Tier I capital ratios to 9pc or 10pc.

This is a wise precaution given that Germany plans to impose a Greek default on Europe’s banking system. But it is also "pro-cyclical". It tightens credit further. Lenders threaten to shrink their loan books to meet the target rather than dilute their share base by raising money in a hostile market.

If governments are forced to step in, it will not be much prettier. The IMF pitches fresh capital needs at €200bn, but what if Credit Suisse is nearer the mark at €400bn? Such sums would push the public debt of several states over the danger line, intensifying the vicious circle as banks and sovereigns drag each other down.

Indeed, it you look at each component of the Grand Plan, every one creates a secondary chain of consequences that may ultimately prove self-defeating. It is why I fear there may be no plausible solution to Europe’s crisis. The structural damage has already gone too far.

We are told the Franco-German plan will offer Greece debt-relief worth having, perhaps a 50pc haircut for banks. Investors are understandably furious. This unpicks the voluntary accord for 21pc haircuts agreed in July. "A deal is a deal," said Charles Dallara from the Institute of International Finance (IIF). Moreover, 50pc is not enough. It creates a banking panic without actually solving Greece’s problem.

A third of Greece’s €364bn debt is owed to the IMF, EU, and ECB. That is deemed untouchable. Angela Merkel has so far managed to deflect popular anger over bail-out loans by insisting that they have not cost German taxpayers one Pfennig.

Stephane Deo from UBS said Greece might have to "repudiate its debt entirely" with a 100pc haircut for banks to give itself enough oxygen to breathe again. This would be an earthquake.

No sane investor believes this will stop with Greece. Portugal is in much the same trouble, despite the heroic austerity drive of premier Pedro Passos Coelho -- a latter day Marques de Pombal. The country’s total debt will top 360pc of GDP next year, and its current account deficit is stuck near 10pc of GDP. This mix is worse than in Greece. It is untenable.

We all told too that the EU’s €440bn bail-out fund (EFSF) -- at last approved after high drama in Slovakia -- will be ramped up with "leverage". It is assumed that German lawmakers will tamely go along with this, a mere three weeks after finance minister Wolfgang Schäuble seemed to promise that no such that leverage would occur.

The proposal du jour is Allianz’s "Achleitner Plan", letting the EFSF guarantee the first tranche of losses on bonds: 40pc for Greece, Portugal, and Ireland; 25pc for Italy and Spain. This would boost coverage to nearly €3 trillion of debt issuance.

This plan is dangerous. It concentrates risk, like a Lloyds spiral syndicate, or the "CDOs" and other instruments of legerdemain in the US subprime bubble. There is a high chance that this bluff would be called if Europe tips into a double-dip recession.

Credit markets have already begun to issue their verdict. Yield spreads on the EFSF’s 10-year bonds have almost doubled over Bunds since July. French spreads jumped last week to a post-EMU record of 92 points. Remember that France’s banking liabilities are 409pc of GDP (ECB data), compared to 338pc for Spain, 331pc for Germany, 250pc for Italy, 213pc for Greece.

Any such leverage must inevitably cost France its `AAA’ rating, with parallel effects in Austria as it struggles with a wave of fresh woes in Hungary, Ukraine, and the Balkans. This sets off its own treacherous dynamic.

Even if the IMF and the China-led `BRICS’ were to step with in half a trillion or so, this would create a fresh problem. Foreign purchases of EMU bonds would force up the value of the euro. The effect would tighten the trade noose even further on Spain, Italy, and France. Perhaps that is why Brazil’s Guido "currency war" Mantega likes the idea. It is exchange manipulation behind diplomatic cover.

There is much talk of EMU fiscal union, most recently the "Soros Plan". But what Germany means by EU economic government is better policing of Club Med budgets, not debt-pooling or eurobonds. It should be clear after the ruling of the German constitutional court last month and the fiery debates in the Bundestag that Berlin will not alienate its sovereign fiscal powers to the EU.

Merkozy’s Grand Plan may buy time. It may shift the stress point from one part of the unworkable structure to another. But it cannot conjure away the 30pc gap in competitiveness between Germany and Latin Europe that has built up over fifteen years. It is this intra-EMU currency misalignment that is asphyxiating Club Med and destroying the banks.

The ECB can of course save Euroland, if it is willing to launch stimulus a l’outrance with bond purchases near 20pc of GDP -- like the Bank of England. A reflation policy would undoubtedly lift the South off the reefs, perhaps by targeting M3 growth of 5pc in Italy and Spain for three years. It would allow EMU laggards to claw their way to back to viability.

Any such attempt to correct North-South imbalances from both ends requires an inflationary boom in Germany. That is the price that Germany must pay. But as events have made all too clear over recent months, this runs smack into German ideology and the Teutonic granite of the Bundesbank.

So perhaps there is no solution for EMU after all. Kultur is the ultimate economic fundamental.