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Tuesday, 29 November 2011

Preparations for collapse of the Euro


Italy Is Closer To Collapse Than Anyone Realized, And So Is The World

27 November, 2011

Some stories in the European press (La Stampa - Zero Hedge link) suggest that Italy is working on a very big loan package from the IMF. I have no doubt that there are ongoing discussions. There have to be. Either someone puts a finger in the dike or Italy goes tapioca.

That thought is difficult for me to fathom. How could we be so close to the brink? At this point there is zero possibility that Italy can refinance any portion of its $300b of 2012 maturing debt. If there is anyone at the table who still thinks that Italy can pull off a miracle, they are wrong. I’m certain that the finance guys at the ECB and Italian CB understand this. I repeat, there is a zero chance for a market solution for Italy. Either the ECB (aka Germany) steps in and underwrites the debt with some form of Euro bonds or the IMF (aka the USA) steps in with some very serious money.

I have acknowledged in recent articles that I misread the Italian story. I didn't see this coming at the pace that it has. Italian bond yields more than doubled in a month. I was not alone in this very big misread. I believe it has caught everyone flatfooted. Central bankers and finance officials all over the globe are crapping in their pants. 

I think the Italian story is make or break. Either this gets fixed or Italy defaults in less than six months. The default option is not really an option that policy makers would consider. If Italy can’t make it, then there will be a very big crashing sound. It would end up taking out most of the global lenders, a fair number of countries would follow into Italy’s vortex. In my opinion a default by Italy is certain to bring a global depression; one that would take many years to crawl out of. The policy makers are aware of this too.

So I say something is brewing. And yes, if there is a plan in the works it must involve the IMF. And yes, it’s going to be big.

Please do not read this and conclude that some headline is coming that will make us all feel happy again. I think headlines are coming. But those headlines are likely to scare the crap out of the markets once the implications are understood.

In the real world of global finance the reality is that any country that is forced to accept an IMF bailout is also blocked from issuing debt in the public markets. IMF (or other supranational debt) is ALWAYS senior to other indebtedness of the country. That’s just the way it works. When Italy borrows money from the IMF it automatically subordinates the existing creditors. Lenders hate this. They will vote with their feet and take a pass at Italian new debt issuance for a long time to come. Once the process starts, it will not end. There will be a snow ball of other creditors. That's exactly what happened in the 80's when Mexico failed; within a year two dozen other countries were forced to their debt knees. (I had a front row seat.)

I don’t see a way out of this box. The liquidity crisis in Italy is scaring us to death, the solution will almost certainly kill us.

Note: 
The news announced last week where the IMF is providing EU countries a new "crisis" lending facility equal to 5Xs their IMF quota is a joke. What has been offered is a drop in the bucket against what is required. The La Stampa story today and this discussion are about something separate and distinct. What would be required is a step without precedent. It would dwarf what the IMF put forward just a few days ago



IMF Says There Are No Talks Underway With Italy on Rescue Finance Program

27 November, 2011

The International Monetary Fund said it isn’t discussing a rescue package with Italy and Japan said no such talks have occurred within the Group of Seven, amid concern that Italy will struggle to bring down borrowing costs.

The Washington-based lender isn’t in discussions with Italian authorities on a program for IMF financing, a spokesperson for the fund said today in an e-mailed statement. Italy’s La Stampa newspaper reported that the IMF may be preparing a loan of as much as 600 billion euros ($798 billion) to support Italian efforts to restore investor confidence.

“The IMF simply does not have the resources” on its own for such aid, Marc Chandler at Brown Brothers Harriman & Co., chief currency strategist at the bank in New York, wrote in a note to clients. It’s also unclear whether the fund would be able to get agreement on leveraging its lending capacity to such a degree, he wrote.

Italy has seen yields on its benchmark 10-year government bonds soar above 7 percent this month as investor skepticism about the nation being able to sustain its debt load deepened. Aid of about 600 billion euros would “essentially” allow Prime Minister Mario Monti’s administration to stay out of the capital markets for 12 to 18 months as it implemented fiscal tightening and sought to win back bondholders’ confidence, Chandler said.

Italy Plans
Japan’s government isn’t sure whether Italy wants a 600 billion-euro IMF rescue, a Japanese government official said on condition of anonymity because of his ministry’s policy. The G-7 hasn’t discussed the issue, the official said.

The IMF, which extended one-third of the rescue packages for Greece, Ireland and Portugal, had about $390 billion available for lending as of Nov. 17, according to data posted on its website. The Italian daily reported that the IMF had several options to increase its firepower, including coordination with the European Central Bank.

Italy would pay an interest rate of 4 percent to 5 percent on the loan, La Stampa reported, without saying where it got the information.

“Schemes to leverage the IMF, which the proposal seems to assume, quickly run into political and technical difficulties,” Chandler said. “It is not clear who bears the cost of the risk. It is not clear that leveraging the IMF would be acceptable to a sufficient number of members.”

Bank of France Governor Christian Noyer said today that markets have forgotten Italy’s strengths, including a strong industrial base. Euro-area bond markets “are not functioning normally,” he said at a forum in Tokyo.



Inner Workings of Currency Trades Are Being Readied for Euro Breakup


28 November, 2011

Companies that provide the plumbing for the $4 trillion-a-day foreign-exchange market are testing systems that could handle trading of previously shelved European currencies.

ICAP PLC, which operates the biggest system for enabling currency trades between banks, said Sunday that it is prepping electronic-trading systems for a possible exit by Greece from the euro zone and a return of the drachma, the country's previous currency.

CLS Bank International, whose platform enables banks to settle their currency trades, is running "stress tests" to prepare for a dissolution of the euro, people familiar with the matter said.

The moves are signs of deepening concern that at least one country might leave the euro. Banks, analysts and investors are preparing for what many of them say is an increasing likelihood of a euro-zone breakup, either completely or in parts, leading to the potential return of currencies such as the drachma, German mark or Italian lira. That scenario appeared far-fetched just a few months ago, but a growing number of analysts and investors now say they have no choice but to get ready, even if a breakup never happens.

While many of them are concerned about the financial fallout from a euro-zone meltdown, including the prospect of a global financial crisis, the burden of handling such a change would fall heavily on the inner workings of the currency market. For operators of currency systems, it presents the largest challenge since the euro was introduced in 1999.

European leaders are still working to find a resolution to the debt crisis, though investors are losing faith that they will be able to control the rolling contagion. On Friday, Italy paid a euro-era high to sell short-term debt, following a similarly poor auction by Spain earlier in the week. Even an auction last week from Germany, considered the bloc's safe core, garnered surprisingly weak demand.

Several politicians have acknowledged that the situation is increasingly perilous. Italian Prime Minister Mario Monti on Friday said top European leaders raised the prospect of the end of the euro, acknowledging in a meeting with him that the collapse of Italy's austerity measures would likely mean the end of the 17-member currency union.

U.K. Chancellor of the Exchequer George Osborne said Sunday the government has stepped up its planning measures in recent months to be prepared for a possible collapse of the euro zone. The U.K. isn't a member of the euro zone, but it is home to Europe's financial hub and is the world's biggest currency-dealing center.

"Countries like Germany and France have now openly asked the question whether countries like Greece can stay in the euro," Mr. Osborne told the British Broadcasting Corp. "It is a very, very difficult and dangerous situation."

Leaders of the euro zone are slated to meet again this week to try to shore up plans to contain the bloc's burgeoning debt crisis. 

Proposals on the table include bulking up a bailout fund, and some policy makers have called for the European Central Bank to do more to bolster government bond markets, where yields on sovereign debt have shot up in recent weeks.

"It is becoming increasingly evident that institutional investors are frantically shuffling through a menu of post-euro scenarios," 
analysts at independent research firm GaveKal Research wrote in a report Friday. "The fact that investors are even considering such options underlines the current key problem for the European bond market: credibility."

It isn't uncommon for financial institutions to prepare for worst-case scenarios, even if they don't rate them as having a high likelihood.

Bank of America Merrill Lynch analysts in London issued a report on Friday that suggested how the euro would react to any breakup, and placed a value on individual currencies from the mark to the French franc to the lira. While a breakup isn't a "base-case" scenario, the analysts noted, "It is worth considering."

Analysts at other banks, including Japan's Nomura Holdings, have also released reports discussing the prospect of the end of the euro. Nomura has advised clients to check the fine print of their euro-denominated bonds to ascertain whether they could be converted into local currencies, such as the drachma, which could quickly plunge.

Barclays Capital last week said almost half the 1,000 investors it surveyed thought at least one country would leave the euro in 2012.

ICAP's executives say their preparations have focused on defining the relationship between the drachma and other currencies and how currency pairs might be quoted.

"What precipitated this were customer concerns," said Edward Brown, executive vice president in business development and research at ICAP.

The firm has been testing technology that would allow dealer banks to trade the drachma against the dollar and the euro, the executives said. They said the measures taken in recent weeks are precautionary and that the currency won't be accessible for trading unless required by market events.

Firms such as ICAP are attempting to anticipate what would be likely to happen in the hours and days of the initial shock if a breakup were to occur.

ICAP executives say their drachma project could be used as a roadmap for how to prepare for an outcome involving multiple currencies exiting the euro. The firm has dusted off old drachma templates for spot foreign-exchange and derivatives called nondeliverable forwards, which were archived after Greece joined the euro a decade ago and which serve as the nuts and bolts of a trade-matching engine.

Global economic recovery petering out - OECD


28 November, 2011

PARIS: The global economic recovery is running out of steam, leaving the euro zone stuck in a mild recession and the United States at risk of following suit, the OECD said on Monday, sharply cutting its forecasts.

The threat of even more devastating downturns looms if the euro zone does not get to grips with its debt crisis and US lawmakers fail to agree a spending-reduction plan, the Organization for Economic Cooperation and Development warned.

In the absence of decisive action from euro zone leaders, the European Central Bank (ECB) alone has the power to contain the bloc's crisis, the Paris-based OECD said. In the United States, however, the Federal Reserve had little ammunition left.

While solid growth in big emerging economies would provide a boost, slumping global trade would drag on Chinese output, the OECD said.

Its twice-yearly Economic Outlook forecast world growth would slow to 3.4 percent in 2012 from 3.8 percent this year.

That marks a sharp fall from its previous outlook in May, when the OECD estimated the world economy would grow 4.2 percent this year and 4.6 percent in 2012.

Struggling to contain an unprecedented debt crisis, the euro zone has already entered a recession and will eke out growth of only 0.2 percent in 2012, the OECD said, slashing its forecast from 2.0 percent in May.

CENTRAL BANKERS TO THE RESCUE?

The OECD said many key questions about the euro zone's response to the debt crisis remain unresolved, raising doubts about even the bloc's most solid economies, as demonstrated by Germany's difficulties placing bonds with investors last week.

"What we see now is contagion rising and hitting probably Germany as well," OECD chief economist Pier Carlo Padoan told Reuters in an interview.

"So the first thing, the absolute priority, is to stop that and in the immediate the only actor that can do that is the ECB," he added, urging the central bank to commit to a creating a cap on government bond yields as a way of calming the crisis.

With the Federal Reserve already flooding the financial system with liquidity, the US central bank has even less room to act if the world's biggest economy hits a downturn. That prospect was made all the more real by the failure of Congress to agree a deficit-reduction plan, without which deep spending cuts would be triggered.

"The resulting fiscal tightening, which would come automatically, would in our view likely generate a recession in the United States," Padoan said.

Provided that the Congress does reach an agreement, then the US economy is set to grow 1.7 percent in 2011 and 2.0 percent in 2012, down from May forecasts of 2.6 percent and 3.1 percent respectively.

With world trade growth projected to slow to 4.8 percent in 2012 from 6.7 percent this year, even China would not be spared a sharp slowdown, the OECD said.

It forecast that growth in the emerging Asian economic power would slow to 8.5 percent in 2012 from 9.3 percent in 2011.

Slower global trade and confidence knocked by the euro zone's debt crisis could trip up Germany, which the OECD estimated would grow only 0.6 percent in 2012 after a 3.0 percent expansion in 2011. Europe's biggest economy has probably entered a shallow recession at the end of the year, the OECD said.

In a rare bright spot, the Japanese economy was seen rebounding sharply after this year's earthquake and tsunami to achieve growth of 2.0 percent in 2012 following a contraction of 0.3 percent in 2011.

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