Market Review 23 November 2010

Last week was a choppy week with a bad day on Tuesday but a good day on Thursday. There was a hint before the weekend that the Irish and the EU would reach some form of agreement. In the event, the Irish agreed to make an application to the EU and the IMF for financial assistance and were able to announce that by 9pm on Sunday evening. Clearly, the purpose of the delay was to allow the Irish to win their point that Irish corporation tax should not be increased from its current rate of 12.5%.

There are more negotiations to come. In particular, some agreement on the likely future structure of the Irish banking system. For the time being, enough has probably been done to give the euro respite. However, the Irish problems are a symptom of the wider problem. There are clearly differences of opinion as to how monetary policy in Europe should be conducted.

A picture, they say, is worth a thousand words and the picture below, provided by CrossBorder Capital, shows the growth in the balance sheets of the three major central banks: the US Federal Reserve; the European Central Bank; and the Bank of Japan up to the end of August this year.

The top line shows the increase in the US Federal Reserve’s balance sheet – about 60% since the Lehmann crisis. The bottom line shows a 15% increase in the size of the Bank of Japan’s balance sheet and the central line the erratic behaviour of the European Central Bank. The US Federal Reserve has been admirably pre-emptive. Indeed, although the line appears to be falling away in the most recent months, that is about to change as the US Federal Reserve’s QE2 begins.

The Japanese have clearly moved in the same direction as the US but sluggishly and ineffectively, without having any significant impact on the external value of the Japanese yen. But the most striking picture is the extraordinarily erratic behaviour of the European Central Bank, which has reacted with admirable alacrity to crises but without the conviction that a long-term policy would provide. If anything, the ECB would prefer not to have a long-term policy other than price stability. The ECB clearly does not believe that it has a role to sustain economic growth in Europe.

As Juergen Stark, an ECB Board member, put it last week “the phasing out of our liquidity support measures will continue after the end of the current quarter and, in my view, conditions in both money and financial markets have improved significantly over recent months, notwithstanding the most recent tensions in some segments of the European sovereign debt market.”  The ECB’s emergency measures “were the exceptional response to exceptional circumstances” and that the central bank’s “unambiguous mandate” is “to deliver price stability”.

The German view is clear. The Germans do not want to see the ECB’s balance sheet corrupted. Bundesbank President Axel Weber opposed the European Central Bank’s decision to start buying government bonds six months ago. In the context of the current Irish crisis, Weber objects to the ECB eroding its independence by financing debt-strapped nations and keeping banks on life support. The ECB probably does not want to become an active buyer of peripheral debt again or take a lot more risk onto its balance sheet. It is wrestling with an opaque and confused fiscal regime. In that sense the ECB must be relieved that it is European governments that will bear the burden of the latest Irish bank bail-out.

In some ways, the ECB’s position is deeply unenviable. It is responsible for a single currency required to service very disparate countries. The euro itself was a political construct. The consequences of its creation on its members were always likely to be profound and were expected to be played out over a long period of time. The Eurozone itself is still going through the consequences of the original introduction of the Euro. The euro’s launch nine years ago initially led to a convergence of interest rates within the euro area, which in turn boosted domestic demand particularly in the peripheral EMU countries.

As a result, the aggregate EMU current account surplus shrank but intra-EMU imbalances rose. With the financial crisis 2008/09 and the government debt crisis of 2010, peripheral countries have run into difficulties funding their twin deficits. The peripheral countries, impacted by the European government debt crisis, will seek to boost growth by exporting more and importing less. Among the larger EMU countries, Spain, the pre-crisis import champion, has already halved its current account deficit. However, Germany and the Netherlands, the main export orientated European countries with large extra-EMU current account surpluses, present formidable competition and, frankly, are likely to remain strongly and successfully export-oriented.

The difficulty, therefore, of a fixed currency regime or, in the case of the Eurozone, a single currency regime is that adjustments to imbalances have to take place internally and cannot take place externally. Internal adjustments, of course, have much greater domestic political consequences. It is hardly surprising, therefore, that German insistence on rectitude is causing growing anger from its neighbours.

The Irish Times last week said that “Fiana Fail should be ashamed to surrender sovereignty” for a “German bail-out with a few shillings of sympathy from the British Chancellor”. The newspaper reminded its readers that Irish rebels had fought for independence during World War I boasting that they “had fought neither king nor Kaiser but only for Ireland.” This is heavy and emotional stuff.

One of the consequences of the initial regime of interest rate convergence and peripheral boom was a massive increase in cross border bank indebtedness.

British banks currently have some US$222 billion of exposure to their Irish counterparts. German banks have only slightly less at US$206 billion. The US’s exposure at the end of the first quarter, according to BIS, was US$114 billion. These are big numbers and the tentacles stretch in all sorts of directions. In the UK, the Royal Bank of Scotland has 52.5 billion of Irish loans – split between 38 billion in Ulster and 15 billion elsewhere. In Ulster, 60% of the book is mortgages, 14% property and the rest corporate loans. £3.2 billion of loans are non performing and £1.3 billion of provisions have been booked against these (40%).

Elsewhere, the loan book is broadly split – half residential and half commercial property. The bank has booked £10 billion of provisions on this part of the book. Lloyds, on the other hand, has £26.7 billion of Irish loans, £11.7 billion of which are impaired (44%) and £4.9 billion of provisions (41%). Meanwhile, Irish house prices fell a further 4% in the third quarter. The Bank of Ireland, which passed the European Stress test in May, might fail today. Ireland, for one, could do with a substantial dose of European quantitative easing.

On 12 November, the US’s programme of quantitative easing began with $6-$8 billion of medium dated US Treasuries. Over the period to mid December, the US Treasury intends to buy $105 billion in US government securities – $75 billion being part of the $600 billion new programme and $30 billion being principal payments from agency debt.

Where will all the stimulus go? The answer, of course, is most places. It will provide an additional stimulus to the emerging markets. The Institute of International Finance recently reported that estimates net flows of inward capital to the emerging markets had been revised sharply upwards for 2010 from US$709 billion to US$825 billion. A British economist, Gavyn Davies, recently suggested that “past experience strongly suggests that the emerging world will be unable to declare monetary independence from the liquidity injection likely in the developed world”.

Already the scale of capital flows into the Asia and Latin America has exceeded the peak levels reached in the previous cycle of 2006/07. The Asian inflow alone is about 60% above that level. The recent tentative introduction of capital controls in Brazil and Korea are hardly sufficient to deter the disintermediation of the US stimulus. Very low interest rates will merely reinforce this. Earlier this month, Mexico issued a billion US dollars of 100 year paper priced to yield 6.1%. The only effective way of cauterising these flows would be for a realignment of currencies to take place, which is unlikely.

Despite a lot of criticism, Chairman Bernanke has been defending his recent actions with a degree of moral zeal. He pointed out on Friday in Frankfurt that the best way to underpin the US dollar and support global recovery “is through policies that lead to a resumption of robust growth in a context of price stability in the United States”. In an Op-Ed column in the Washington Post on 5th November, he suggested that the present level of “unemployment in the United States and elsewhere was unacceptable”. Even some Europeans agree with this.

Dominique Strauss-Kahn, the IMF Chief, pointed out recently that 30 million jobs had been lost since the financial crisis, three quarters of these in the richer economies. We suspect that “the prospect of high unemployment for a long period of time“, will remain “a central concern of policy for a considerable time to come”, at least if Mr Bernanke is to be believed. In this context, the British reluctance to follow suit seems odd and the behaviour of the Europeans positively schizophrenic.

Events rather than principle are likely to continue to drive European monetary policy. We would not be surprised to see a practical resumption of the buying of securities by the ECB in due course. The immediate problems in Ireland may be solved shortly but that will still leave Portugal, Spain and maybe, eventually, France.

Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30 years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.