Through the latest financial crisis, I warned readers that the costs of banking bailouts in Europe would far outstrip those of the United States. Following from my “quick and dirty” summary at the bottom of last week’s article (see Dismal math, Asia Times Online, October 4, 2008), this article expands on the subject at some length.
Before delving into the minutiae of total costs to the government though, a brief recap of recent events as follows:
- Ireland guaranteed all bank deposits as well as interbank lending last week for all its banks, in effect providing a sovereign guarantee on the entire banking system at an indeterminate cost to taxpayers
- Other countries in Europe including Greece followed suit in terms of guaranteeing all bank deposits. Anecdotally, this wasn’t enough to actually stop outflows of funds from the banking sector in some countries.
- Germany stepped in to directly rescue Hypo Real Estate over the last weekend, after a previously agreed rescue plan involving other banks fell through, leaving the government with the wreckage.
- Even the usually insular French got into the act by suggesting the creation of cross-border bailout fund that was, however, rebuffed by Germany, as the latter believes its financial institutions aren’t facing any imminent danger in the current market crisis.
- Iceland had to nationalize its largest bank Kaupthing on Thursday, marking the third bank after Glitnir and Landsbanki to be taken over by the government. This drove strategic trades that are discussed later in the article.
- The UK announced the most comprehensive series of bank interventions seen of late, marking a culmination of government involvement in the sector after the collapse of Northern Rock last year (see Rocking the land of Poppins, Asia Times Online, September 22, 2007); under the plan the government will provide up to 500 billion pounds (US$844 billion) in assistance for the sector including fresh injections of capital that have been modelled on the rescue of AIG by the US government.
- Spain announced a 50 billion euro (US$68 billion) emergency fund earlier this week to provide liquidity by buying assets directly from Spanish banks. Nordic countries like Sweden and Denmark also extended deposit guarantees and in some cases also covered unsecured debt issued by the banks.
- In conjunction with the US Fed, both the Bank of England and the European Central Bank this week cut interest rates by 50 basis points, signaling their willingness to provide greater liquidity to the broader economy while suspending inflation targeting for the interim period. This move will cut the incomes of millions of pensioners across Europe, therefore the overall economic impact on the “old” continent is not a straightforward positive as it is in the case of the US.
Who bails out the guarantors?
As highlighted in my previous article on the subject, the major hurdle that needs to be crossed by Europe at some point in the near future pertains not so much to the health of their banking systems as the viability of their sovereign finances. The idea of a “risk-free” European sovereign appears an oxymoron at the current juncture.
In response to the above-mentioned article, a reader complained that estimates for repaying bank debt should be based not so much on the total borrowing but the actual scale of losses incurred. The steps taken by European governments detailed above point to their wholesale undertaking of banking liabilities; secondly, I do not believe that government-owned entities will be managed any better (and probably a whole lot worse) than private enterprises, especially in lucrative areas such as banking.
Even giving generous allowances for this reader’s view doesn’t change my fundamental conclusion from last week, which is that European sovereigns simply cannot afford the banking bailout that is being proposed: which is perhaps the main reason for Germany to demur on continent-wide bailout that would unfairly expose German savers to the profligacy shown by Spanish and Irish bankers.
Let us first look at select European countries, continuing from the analysis of last week.
The first column details bank assets as percentage of gross domestic product. This figure is derived from looking at the biggest banks in each country, and then rounded down – for example, 1,369% in the case of Iceland became 1,300%. Since most European banks can no longer borrow in the interbank market or in bond markets, governments will need to step in to provide funding.
The second column makes a generous assumption that such funding is capped at only 25% of the asset base (in practice, for countries at the top of this table the actual number will be closer to 40%). While some will argue that such funding is not a “loss”, governments are likely to tie them to social objectives such as uneconomic lending to individuals and small companies, thereby making the program a permanent diversion of resources to the banking sector.
The third column details the cost of the UK-style injection of capital, which is again calculated at a liberal (10%) rather than conservative (25%) proportion of outstanding assets. Both these columns are expressed as proportion of the underlying GDP to make the overall analysis comparable.
The next two columns detail the share of residential mortgages to GDP and the cost of a bailout at a loss proportion of 25%. This is important in the case of Europe because of the similarity to Japan in terms of the meteoric rise in property prices combined with the increasingly challenged demographic situation. In the case of Japan, property prices fell 65% from peak to trough; a conservative estimate of losses in the case of Europe would be around 50%. From this loss figure we subtract existing equity contribution of mortgage borrowers (again a liberal 25% of outstanding) to arrive at a loss of 25%.
Will the governments of Europe bail out individual borrowers in this fashion? Being liberal democracies that have just stepped in to rescue their much-reviled banking systems, it appears almost a certainty that such borrowers will be rescued. It is quite likely that politicians will argue about the need for compassion under the circumstances; this is also related to my point above on government assistance on bank funding that will likely be tied to such assistance to the mortgage borrowers.
The next stage is to calculate changes in sovereign leverage after including the above changes – in the main, the impact of providing direct funding for banks, capital injections and compensating residential mortgage borrowers for their losses.
Adding these figures to total government debt and including contingent liabilities such as guaranteed interbank funding gives a very significant boost to debt/GDP numbers across Europe (second column above).
For comparison, I have also included five-year credit default swap (a metric of what it costs to insure against a sovereign default) spreads in the third column. The point with this column is the trend for Iceland which now trades significantly wider than most sovereigns (for example Indonesia is quoted at around 600 basis points while China is quoted at 110 basis points). The rest of Europe doesn’t have the same level of spreads, but going down the path that Iceland did makes it quite likely that one or more of such countries will find itself in a similar predicament at some point.
With this information, it becomes easy to adopt an International Monetary Fund-style framework wherein the governments are required to show budget surpluses in order to repay debt. Most of the European sovereigns mentioned above currently have a budget deficit, which suggests the need for bigger moves in government expenses than appears superficially.
For example, countries like France, the UK and Italy all currently post budget deficits of around 3% of GDP; therefore a swing to 1% surplus actually means a 4% move in the ratio of government expenses to incomes. The table below shows the number of years that governments would need to repay debt while running the surpluses mentioned – for example, Switzerland would take 170 years to repay its gross government debt if it ran a surplus of 2.5% of GDP annually.
|Time to repay debt (years) / Annual Budget Surplus|
These are horrible figures for even developing countries with young populations to bear. When the demographic angle is considered, that is the ageing of Europe that presents significant threats to the servicing of current debt loads leave alone additional borrowing to bail out the banking system, it is quite easy to conclude that European sovereigns are about as creditworthy as the average overextended American burger-flipper who “owns” two condominiums in Miami.
The extraordinary steps taken this week across Europe highlight the flaws of the banking system, but equally of the willingness of politicians to be seen riding to the rescue of the unctuous bankers.
Iceland’s example is in particular startling. Confronting a virtual run on its banking system, the country tried to stem the tide by nationalizing the troubled institutions only to find that credit markets in turn shut for the sovereign itself. This necessitated some desperate calls for help that went completely unanswered by the capitals of Western Europe.
Only Russia bothered to return the phone call, and it may be willing to provide longer-term assistance for the country. It is perhaps not the output of the Icelandic fishing fleet that the Russians are after though; the country’s strategic position during the Cold War proved an unassailable advantage for the US.
With both the US and EU in deep financial trouble, the chances of any quick rescues of Iceland looks depressingly low, giving more than enough room for the Russians to negotiate non-financial terms for their willingness to help. Pretty soon, it is possible that Arab countries could look to providing similar deals to take over parts of their old empire including Turkey, Spain et al by using the leeway granted by the current financial crisis.
Utterly pointless Europe (Asia Times Online, August 16, 2008) dealt with the longer-term negative outlook for a continent that proved unwilling to stand up for itself in the face of Russian aggression in Georgia. The wonders of the current financial crisis are such that what looked like a long-shot just a little while ago now looks like a slam dunk possibility.