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.

Axel Merk: The US of E has Arrived!

Axel Merk published his latest Merk Insights entitled "United States of Europe has Arrived!". With lots of talk about a fiscal union, a banking union and a potilical, Merk wonder if we are assiting to the birth of the United States of Europe.

Here's the full letter:

A vision "Towards a Genuine Economic and Monetary Union" has just been published by the European Union. Key components include integrated financial and budgetary frameworks. The goal is to achieve a “strong and stable architecture in the financial, fiscal, economic and political domains.” For a vision to work, it has to be realistic. The budgetary framework calls for “joint decision-making … and … steps towards common debt issuance.” Given that German Chancellor Merkel was quoted as saying Europe will not have shared liability for debt as long as she lives, such goals seem a tad ambitious. Understanding that Merkel is like a mother to the United States of Europe, she should consider nurturing it with vitamins, love and care.

Love

Love has a lot to do with communication. And while it should be so easy, we all know that we sometimes neglect to communicate with our loved ones. Translating that to the Eurozone, take charge, be a leader and communicate! Merkel may not be a Reagan, nor a Thatcher, but it ultimately falls upon her shoulders to frame the discussion. If she does not agree, there is little others can do to move forward. Tough love is okay, too…

Care

Intensive care is what peripheral Eurozone countries are in. Let’s focus on the good news in terms of European integration: those countries that require assistance have yielded sovereign control to the European Commission. Presto! That’s the key element of the union. Those that have proven prudent in managing their budgets don’t need to yield control to Brussels bureaucrats. But those that are not capable do. It may sound like an unbalanced union, where not everyone is ceding control, but given the political realities, policy makers ought to leverage the cards they are dealt.

Regarding the so-called banking union, the same principle applies: countries that have been incapable of cleaning up their own banking system, ought to cede control. Seizing control from national bank regulators, including a European resolution scheme are key; but unlike the proposed vision published by the European Union, such a scheme must start with the more modest goal of first intervening where calls for help have been issued.

Vitamins

The way you leverage on the framework is by providing hope and support to those that succumb to it. Some vitamins, when administered in too high a dose, may be toxic. The European Stability Mechanism, the ESM, has shown such toxic characteristics. Because the ESM subordinates all other debt, it has made such subordinate debt toxic. The ESM is a last resort bailout scheme, not a tool to promote a “strong and stable architecture.” The discussion about the solution must include Eurobonds.

Having said that, vitamins do little good if not accompanied by underlying lifestyle changes. Put another way, as long as policy makers look for evermore creative ways to finance rather than to reduce debt, the underlying disease won’t be cured. Ultimately, debt will need to be reduced. The way it looks, it may be more likely be through default than sustainable fiscal policies.

Squaring the circle

The price for living beyond one’s means and failing to regulate one’s banking system should be the loss of sovereign control over budgeting and regulation. This part is already reality, as evidenced by the various bailout schemes in place.

What is not in place is a mechanism to allow those chronically sick children to get back on the right path, for national governments to conduct policy with enough dignity, so that political backlash won’t tear those countries apart.

The solution must include a tough love support mechanism, one where sovereign debt of the country in need is not de facto labeled as toxic. At the same time it is fully understandable that a country such as Finland wants to receive collateral for loans provided to those that have a proven track record of living beyond their means. Once a check is written, it’s rather difficult to decide on where the money is going to be spent. As such, a basis of discussion for the Eurozone should be:

• Countries that want final control over where bailout money is spent, need to accept the seniority status of IMF and ESM money.
• Eurobonds (without seniority over outstanding bonds) should be issued to finance projects that are directly supervised by the European Commission.

If Spain wants a bank bailout that doesn’t jeopardize its sovereign bonds, it must yield control over its banking system. It must accept that fact that its banking system may be too big, that institutions may be liquidated and management teams fired.

It’s too early to write off Europe. In the short-term, expectations are so low that policy makers will have a hard time disappointing. In the meantime, central banks around the world appear to be hoping for the best, but planning for the worst. That may mean easy money, a weak U.S. dollar, with money flowing into currencies of countries whose central banks can afford to not join the fray. To us, it is no coincidence our analysis of recent market data suggests biases of major central banks towards easing, whereas central banks of smaller countries shift towards tightening monetary policy

How to Save the Euro

Axel Merk, Portfolio Manager at Merk Funds has published an update to Merk Insights newsletter entitled "Guide to Save the Euro".

The articles is composed of 3 main parts:

• Fiscal sustainability
  Fiscal sustainability is about revenue and expenses, but also about perception.
• Method 1: Surrendering sovereign control over budgeting process
  When a government asks the IMF to help, tough austerity measures are imposed, a de facto handover of sovereign control to an outside agency
  
• Method 2: Embracing bond market pressures
  It requires dealing with the reality that low interest rates must be earned. It also means that governments have to embrace the reality that they may have to renegotiate some of their debt.

The conclusion is that we should "expect a muddled combination of increased IMF support, increased fiscal convergence, increased focus on strengthening bank balance sheets, increased involvement to keep banks afloat (the ECB is already debating providing multi-year unlimited credit lines), and increased cost of borrowing for Germany. However, this is likely to remain a drawn out process and the tail risks that European policy makers mess this up cannot be ignored, either. We come back to our initial argument: a lot depends on perception. Perception is a function of leadership and a credible path that is likely to lead to results. The prime minister-elect of Spain wasted his first opportunity to make a good impression. The German psyche has been badly wounded by the botched auction. In typical European fashion, another summit has been announced to discuss closer fiscal integration. In case anyone wonders why this process is so painful, it is because the right decisions are politically so incredibly difficult to make."

The full "guide" can be read at http://www.merkfunds.com/merk-perspective/insights/2011-11-30.html

Peter Schiff: The Real Currency Crisis is Coming to the US

Interview with Peter Schiff on Fox Business News (1st of December 2011) where he explains the Eurozone has severe problems but it's nothing in comparison to the United States and that the real currency crisis is coming to the US to the dismay of Fox Business host.

Axel Merk: Overweight the Japanese Yen

As Greece will hold a referendum whether to approve the austerity measures and the "no" will probably win hands down, Merk Funds recommend over-weighting the Japanese Yen and under-weighting the Euro in the short term.

Here's the the full Merk Insights letter below:

Greek Prime Minister Papandreou is throwing in the towel: by calling for a popular vote on austerity measures now, we believe he is almost assured a no vote. This allows Papandreou to say that he tried everything he could to avoid a default, but the people have spoken. Having said that, as we write this analysis, Papandreou appears to be changing his mind and may cancel the idea of a referendum as quickly as it came about. Still, the message is clear: a default is coming.

The sad part is that Greece has not been able to eliminate its primary deficit (the deficit before interest payments), so that it could have the potential to bounce back upon a default. On the contrary, Greece may fall into chaos or anarchy. The threat of such a scenario, in turn, may prompt European policy makers to instigate a Marshall Plan to rebuild Greece. While we can ponder about the Greek drama, it’s paramount to contemplate the consequences for the rest of Europe and the euro.

First, the good news: market pressures should accelerate reform. Specifically, we expect bank recapitalizations will both be accelerated and increased in scope; if you can’t save the sovereigns, at least make the banking system robust enough to absorb defaults. That’s better than any insurance scheme policy makers can come up with.

Expect dramatic actions by policy makers, akin to those seen in October 2008. Just as policy makers did not initially heed the markets then, the pressure is now on to follow through with substance after last week’s sketchy plan to save Europe, and ostensibly, the world. Specifically, pressure on Italian Prime Minister Berlusconi is mounting rather dramatically to engage in real pension reform. In comparison to both Spain and Ireland, which have seen relative market improvements, the markets have scolded Italy. While it is possible to turn the tide, the longer the wait, the more the market will demand.

What would alleviate the pressure is a commitment by the European Central Bank (ECB) to be the lender of last resort for Italy and Spain. However, that’s unlikely to happen, at least not in the short term. As of today, the ECB has a new leader, Mario Draghi. As an Italian, he will be under pressure to be rather hawkish. His first press conference is this Thursday. He could announce a program to buy unlimited Eurozone debt, and sterilize such activities. However, such a move would take the pressure for reform away. And a central bank’s role is not to make the life of policy makers easy. If Draghi were to pursue the route of least resistance, he could easily be labeled as, well, Italian, in his approach to central banking.

Any revised bailout fund for Italy is likely to cost France its AAA rating. France itself also has lots of homework to do. The lesson here is that policy makers always wait until the last minute to engage in reform; some day down the road, the market will focus on the U.S.; at that stage, the U.S. dollar may be under severe pressure: the U.S. dollar is more vulnerable given the significant current account deficit.

So for now, the drama continues. To summarize, expect more on bank recapitalization and reform. A wild card is whether the European Financial Stability Facility (EFSF) is going to be bolstered in earnest. For those politicians that still believe Greece can be held afloat: stop believing in fairy tails and move on. The market will.

As far as our positioning is concerned, we had increased our euro holdings ahead of the summit last week. We have since reduced it. We had also substantially reduced the yen ahead of that summit. Our outlook calls for substantial volatility in all currencies, except for possibly the yen; as such, our risk assessment is currently favoring the yen disproportionally. As October 2008 has taught us, though, rational investors may be forgiven for changing their view of the world on a daily basis… Stay tuned and subscribe to Merk Insights.

U.S. Dollar and Euro - Review and Outlook

Axel Merk & Kieran Osborne, CFA, Merk Funds have just published their outlook for the US dollar, the Euro, the Chinese RMB and several other currencies.

They have a bearish view on the US dollar:

Policy makers in Washington didn’t help appease market concerns: leaving the decision to raise the Government’s debt ceiling to the last minute only exacerbated market fears of a U.S. default and further degraded investor’s view of policy makers; ...Standard & Poors subsequently downgraded the credit rating of the U.S. government, citing the inability of the political leadership to come together and agree on a plan to sustainably rein in the deficit over the long term as a key reason for downgrade. We consider these developments have further eroded the safe haven and reserve currency status the U.S. dollar has held for so long, and continue to view the outlook for the U.S. dollar negatively over the medium to long term.
...
minutes from the FOMC meeting show there was support for further expansionary monetary policy, or quantitative easing, which would constitute “QE3”. It is our assessment that the likelihood of the Fed instigating QE3 has risen significantly, in part due to the weakening economic outlook, but also because of the composition of voting members next year. All three dissenting voices will be replaced in 2012 and the average monetary policy stance of voting members will become much more dovish (only one voting member is considered a hawk – Jeffrey Lacker, the Richmond President)¹. With inflation expectations declining, we consider Fed Chairman Bernanke may again present the need for further easing, arguing deflationary risks have become elevated, or at the very least, that further easing will not generate significant inflationary pressures. We believe the impending FOMC composition may consider this argument compelling, and is likely to err on the side of overstimulation. All of which leads us to believe that the outlook for the U.S. dollar remains to the downside.

even if in the short term there are risk, they are bullish on the Euro in the medium to long term:

Europe certainly has problems, but in an odd way, it is the inflexibility of its political make-up that may lead to a stronger euro over the foreseeable future. ...
Many individual countries find themselves with very weak political leadership, but interestingly, have instigated, in many cases, very strict austerity measures with opposition support. The issues facing the Eurozone are significant, and there is no simple, easy solution; it’s likely to be a drawn out process rectifying years of malinvestment brought about by unconscionably low funding rates for periphery nations (Greece could borrow at rates similar to Germany for years leading up to the crisis). In turn, economic growth may be restrained over the foreseeable future. Note, however, that economic growth is not necessarily a precondition for a strong currency; it is not incompatible to have poor economic growth on the back of a strong currency – just look at Japan.
...
We believe two key reasons have contributed to Japanese yen strength – weak leadership and a current account surplus.
...
On the above two factors, the Eurozone is not so dissimilar to Japan: the Eurozone has a broadly balanced current account, fiscal union is disjointed at best, and many individual nations have very weak political leadership. Furthermore, the ECB has a sole mandate of price stability, and is reticent to provide any direct bailout funding or directed asset purchases to the financial industry, or specific sovereigns, for fear of overstepping its bounds (or being taken to court by the Germans).
...
As a result, we consider the euro can appreciate on the backdrop of weaker economic growth and continued divergence in monetary policies

Finally, they mention they still have a positive view of the Chinese Yuan:

We continue to see upside potential in the Chinese renminbi and believe policy makers will continue to be incentivized to allow the currency to appreciate to tackle domestic inflationary pressures.

The full outlook is available at http://www.merkfunds.com/merk-perspective/insights/2011-10-19.html

The Death of the Euro

Here's an interesting debate about the Euro on CrossTak, RussiaToday on the 14th of October 2011.

How much liquidity is needed to save the Eurozone? Why go in more debt to overcome deadly indebtedness? And is Germany going to remain the prime sponsor of the euro experiment? Will we see the Eurozone change its boundaries? CrossTalking with Andrew Lilico (Clue: He's the man!), Jeff Madrick (Keynesian clown) and Jon Gaun (Eurosceptic) on October 14.

There is also an interesting part in the interview where they discuss whether TARP solved the US problem or not and Andrew Lilico compares the US debt situation with the one's of Italy.