Tuesday, July 31, 2012

Axel Merk: Gold at ECB: Accident or Strategy?

Axel Merk discusses the relatively constant Gold to Asset ratio at the ECB (15%) in his latest Merk Insight letter and tries to analyze if this is done on purpose.

Here's the full letter:

When the euro was launched, the European Central Bank (ECB) held approximately 15% of its assets in gold. That ratio has remained reasonably stable, giving rise to a variety of chatter, including suggestions that it may displace the U.S. dollar. We pursue the question on whether the ECB’s gold holdings are an accident or strategy.

Let’s look at the numbers. Below is a chart depicting the percentage of gold relative to the ECB’s total assets. As one can see, the percentage has remained reasonably stable despite a significant growth in total assets.
ECB Gold Holdings and Gold Price
Total assets of a central bank may be considered a proxy for the amount of money that has been “printed”; it’s a crude measure as it does not reflect physical money printed; nor does it reflect money in circulation; neither does it reflect sterilization activities that also show a rise in assets. Still, a central bank balance sheet is often referred to as the printing press as money is literally created out of thin air (by the stroke of a keyboard) when assets are purchased. Federal Reserve (Fed) Chairman Bernanke has referred to this fiat money feature as the printing press. We like to think of it as super-money, as central bank purchases provide cash to the banking system, allowing them to lend a multiple of the money that has been “printed”. While banks have been reluctant to lend (the velocity of money has been low), the analogy we like to give is that if you give a baby a gun, just because no one gets hurt does not mean it is not dangerous. That said, let’s look at total assets at the ECB:
ECB Gold Holdings As % Of Total Assets
The interpretation shows that while money can be printed, wealth cannot be created out of thin air: as money is printed, gold has appreciated versus the euro. So while inflation has not shown up in indicators such as the Consumer Price Index, monetary easing is rightfully reflected in the price of gold.
Diving a little deeper to determine how much of this is strategy versus accident, let’s look at the gold holdings at the ECB once more:
ECB Gold Holdings: Value and Volume
The ECB marks its gold holdings to market, i.e. uses market prices for gold. The ECB was selling gold from the inception of the euro until the onset of the financial crisis; since then, the ECB’s gold holdings have remained stable. To understand the motivation, one needs to note that when one refers to ECB gold holdings, one is actually talking about Euro area gold holdings. While the ECB holds some gold, most gold is held by the respective central banks (this is not a discussion of where such gold is physically located):
Eurosystem Gold Holdings
Relevant is that each nation in the Eurozone pursues its own agenda with regard to its gold holdings. Germany has resisted political pressure within Germany to sell gold, as Bundesbank (Buba) profits would need to be transferred to the government; the hawkish Buba has indicated that it would be considered selling gold to help finance the government’s deficit. Italy, as one can see, has not sold any gold. Conversely, as a percentage of their holdings, the Netherlands had been rather eager to sell gold up until the financial crisis; Portugal, too, was an aggressive seller. As one can see, gold sales are not particularly related to the financial health of a Eurozone nation, but more to the cultural attitude in the respective nations towards gold.
Let’s cross the Atlantic to see whether the ECB’s gold strategy is undermining the U.S. dollar. The Fed’s gold stock is valued at $44.22 per fine troy ounce. For purposes of the chart below, we adjust the Fed’s gold holdings to market prices:
Fed Gold Holdings
Note that the chart above starts in 2006, so as to focus on the period of the financial crisis. The Fed has been more aggressive than the ECB in printing money. As such, the percentage of gold in relation to total holdings has declined at the Fed in a more pronounced fashion. There is clearly no perfect relationship between the size of the balance sheet and the price of gold, as other factors also influence the supply and demand of gold; however, increasing the supply of fiat money (dollar, euros) may decrease its value when measured in real assets, such as gold. We have in the past referred to the Fed as the champ in printing money (as measured by the percentage balance sheet growth since August 2008), although the Bank of England has, as of late, taken on that title. But we digress.
From what we see, central banks have been scared into holding gold since the onset of the financial crisis. Beyond that, we don’t see an active strategy at the ECB to keep its gold reserves at 15% of total assets. Instead, the ECB’s comparatively measured approach has simply lead to a reasonably stable percentage of gold reserves. Of course that was before ECB President Draghi said on July 26, 2012, that he shall do “whatever it takes to preserve the euro.” (an interpretation of that may be that more money printing is on the way). For now, the cultural differences in responding to the financial crisis (Europe: think austerity; US: think growth) suggest that the euro should outperform the U.S. dollar over the long term, assuming the not-so-negligible scenario of a more severe fallout from the Eurozone debt crisis won’t materialize.
It may help to keep in mind that historically inflation is the response to a deflationary shock. If market forces were left to themselves, we believe the credit bust of 2008 would have caused a major deflationary shock. It’s the reaction of policy makers that fight market forces that may lead to inflation. Bernanke as of late brushed off such pessimism. As the charts above show, however, gold has been a sensitive – and sensible I might add - indicator to the trigger-friendliness of our central bankers.

Monday, July 23, 2012

Axel Merk: Is Spain Jeopardizing the Eurozone?

Axel Merk published his latest Merk Insights entitled "Spain's Molasses Jeopardizing Eurozone?!". He analyzed the debt structure in Spain, and explains that just shuffling debts around won't fix the debt problem, and guarantees must be removed to solve over-indebtedness. Failing to do so will make the global financial system as a whole at risk.

Here's the full commentary:
Spain's regional government debt is in focus again. Spanish 10-year government bond yields are trading near 7.5% as Spain’s central government is expected to bail out its regions – and in return may ask for a bailout itself. Guarantees don’t make a system safer, quite the opposite: everything is safe until the guarantor itself is deemed unsafe. While the failure of any one business of regional government is a tragedy, providing a guarantee puts the system as a whole at risk.

Spain consists of 17 autonomous regions, whose total debt almost doubled in the past three years. Technically, Spanish law forbids the central government from rescuing regional government (in much the same way that the Maastricht Treaty prohibits bailouts of EU countries). The debate on whether the central government should take more control over regional budgets and provide guarantees/bailouts has intensified since January, when the central government implicitly helped Valencia, one of the most indebted regions, with a €123 million loan repayment to Deutsche Bank:
  • Though the central government is prohibited from rescuing regional governments and it denied it has done so, El Pais (Spain's highest-circulation daily newspaper) reported earlier this year that the Spanish Treasury provided implicit guarantee and help to Valencia in repaying the loan to Deutsche Bank. The central government advanced its regular transfers to Valencia by about 10 days to January 3rd. On the next day, Jan. 4th, Valencia was reported to have repaid the loan. It can be viewed as the first implicit bailout from the central government in Spain.
In an effort to impose more control over the spending of regional governments, the Spanish Council of Ministers approved a draft of a Stability and Sustainability Law in late January; one provision is that the central government could oversee the budgets of the 17 autonomous regions and establish penalties for those who do not meet the balanced budget targets (all regions missed the deficit-to-GDP target of 1.5% last year). Not surprisingly, the provision created strong controversy. Socialist-led regions (i.e. Catalonia) criticized the provision harshly, while some conservative-ruled regions (i.e. Valencia) backed the plan. The criticism didn’t stop Catalonia to ask for delays in handing tax payments to the central government.
In May, in a clear sign that troubles for the regions were escalating, Valencia, one of the most troubled regions, was forced to pay what was considered a punitive 6.8% yield to roll over €500 million for six months, more than six times the Spanish Treasury had to pay on the comparable-maturity at the time. By now, the yields have further risen to around 20%.
A highly decentralized budget system
  • Spain is divided into 17 autonomous regions due to historical reasons and cultural differences.
  • Regional governments have historically been granted significant control over spending. They take charge of education, health and social services, which account for 50% of total government expenditures.
  • Regions also have the power to authorize or veto the issuance of public debt.
  • The central government has little ability to interfere regional government spending, but is prohibited by Spanish law to bailout regional governments.
Mismatch in regional fiscal autonomy
  • While regions enjoy high autonomy on spending, the central government retains effective control over regional government revenue.
  • For 15 out of the 17 regions, the central government retains all powers over the collection and regulation of important taxes (i.e. corporate income tax, import duties, payroll taxes). Regional government revenues mainly come from the central government's conditional grants and ceded taxes (set at central level, but collected at regional level). Central grants vary from year to year; they are designed to address regional imbalances. And for some of the ceded taxes, these regions only retain a small share (i.e. 35% for VAT and 50% for personal income tax) after collection.
  • Only two regions are close to the maximum fiscal autonomy. They have full powers over a number of major taxes and retain 100% of ceded taxes.
Regional debt accumulation
  • As a result of the economic recession and housing market collapse, all 17 regions experienced a significant rise in debt. By 2011, the total debt of 17 regional governments rose to €140 billion, accounting for 13.1% of Spain's GDP. This number is up from 6.7% by 2008.
  • 10 out of 17 regions' debt-to-regional-GDP ratio exceeded 10% (versus 2 out 17 by 2008). All regions missed the deficit-to-GDP target of 1.5% last year.
  • The most indebted region, Catalonia, recorded a 20.7% debt-to-regional-GDP ratio and 3.6% deficit-to-GDP ratio in 2011. Catalonia’s 10-year bond yield exceeded 14% at its peak in June.
  • The 2nd indebted region, Valencia, delayed repayment of a €123 million loan to Deutsche Bank in January. Subsequently, the region's credit rating was downgraded by Moody's to junk and it failed to raise €1.8 billion in a bond auction in March. Valencia is a Mediterranean region with many beach-front properties; its economy collapsed after the housing bubble bust.
Last Friday, Valencia was the first region to say it would contribute into a new Spanish government fund to meet its debt-refinancing obligations, as well as to pay suppliers. With that, the Spanish government is now clearly on the hook for the regions’ debt. Not surprisingly, the market is pricing in that reality. Trouble is that Spain’s central government does not have the credibility that it has sufficient influence to turn the regions’ finances around. Unless the Spanish government can assure the markets that it can deliver sustainable budgets – for itself and now the regions as well – it will simply go deeper into the molasses and risks taking the Eurozone with it. And while Spain certainly tries to advance its structural reform, the headlines coming out from the region suggest Spain might be more interested in the European Central Bank (ECB) intervening to help out Spain’s cost of borrowing. As long as debt is merely shuffled around, the Eurozone crisis won’t be solved. And as long as ever more guarantees are provided – from regional to national governments, from supranational issuers such as the European Stability Mechanism (ESM) to the International Monetary Fund, the more the global financial system as a whole may be at risk.