Article / 03 August 2017 at 13:00 GMT

ECB seems to anticipate a European financial crisis

Managing Partner / Spotlight Group
United Kingdom
  • ECB seeks penalties for failing to implement monetary reforms
  • Widening level of disagreement between ECB and individual states
  • Economy is not as bright as imagined
  • Banking system is in an NPL-driven crisis, especially in Italy
European central bank
 The ECB has been stymied in its effort to persuade some 
Eurozone members to implement reforms. Photo: Shutterstock

By Stephen Pope

The European Central Bank has issued a call for harsher penalties to be imposed on Eurozone member nations that fail to implement desperately needed monetary reforms if the region is to avoid a severe financial crisis in both the sovereign and bank debt markets.

Sovereign scale

The warning came after a detailed investigation into member nations' finances by ECB staff. Too many have failed to heed  ECB president Mario Draghi's and vice president Vítor Constâncio's repeated calls for reform and  "more growth-friendly" policies to clear the growing debt within the European single currency region.

This reflects a widening disagreement between the ECB and the individual states which object to the centralised reforms urged by the central bank. However, dig deeper and one perceives a heightened degree of tension between member states and the ECB over the plan and timing of a retreat from the ultra-loose monetary policy that has been in place during the financial crisis, with the benchmark refinancing rate marked at 0.0% in March 2016.
Source: Eurostat and ECB

Economy is increasingly exigent

In the second quarter of 2017, the Eurozone economy grew by 0.6%. This was a mild increase over the first quarter, and an optimist would point out that the region has shown the lowest unemployment rate (at 9.1%) since 2009. The same is true for youth unemployment at 18.7%.

What cannot be overlooked is the tepid inflation in the region. Consumer prices are estimated to have risen by 1.3% year-on-year in July, the same pace as in June and in line with market expectations, according to the flash estimate. However, the inflation rate stood at its lowest level since December last year, as prices of services rose at a slower pace, undermining rising energy costs.

This can be coupled with a slowing rate of growth in wages, which increased just 1.4% year-on-year in the first quarter after rising by 1.6% in the previous quarter. This slowdown is even more worrying if one considers that wage growth in the region averaged 1.8% from 2009 until 2017.

Central banks...from saviour to villain

In a region where sovereign debt was (and still is) too high, the ECB had to join other global central banks and bathe the Eurozone economy with loose monetary conditions in what is best described as “crisis policy”.

Sadly, in the Eurozone, as well as in the US, UK and Japan, growth has not rebounded and, instead of a “V-shaped” recovery, all major economies in the developed world appear to be glued to the bottom of an extended “U-shape”. Hence the attitude in the markets and broader economy has been that once shadowy central banks have become the main actor on the stage.

We have all become too accustomed to the notion that the cost of money is virtually zero. There is an assumption that goes beyond quantitative easing where the central bank was a “best friend” or “BF”. They are now regarded as a “BFF” i.e. a “best friend forever”. It seems that what Mohamed El-Erian described as the “new normal” has, in fact, become the “natural state”.

For all the talk of normalising balance sheets and restoring interest rates to a positive integer the assumption is in place, especially in the Eurozone, that the central banks will intervene if the economy is threatened again. Talk of normalising balance sheets would be forgotten.

Dealing with damaging debt

What is troubling for all these regions is that tangible efforts to established a sense of fiscal order have apparently vanished.

The US appears to lurch from one White House road bump to another, with very little policy progress . The US debt to GDP stands at 106.1%, and Congress must do two things before there can be any attempt to move on tax reform. First, the debt ceiling must be raised and spending authorisation for the new fiscal year beginning October 1 is needed.

In the UK, the general election of June 8 did not deliver a strong and stable Conservative government, so plans to reduce the debt to GDP level from 89.30% appear dead in the water. While that issue is on the back burner, the government still seems incapable of offering a single vision of what Brexit should look like. If there were another snap election driven by a lack of confidence, business investment would be further delayed as no-one knows how Labour leader Jerem Corbyn would finance his election pledges.

Japan's public debt exceeded ¥1 quadrillion (= 10 to the power 15) or $10.46 trillion and stands at 250.4% of GDP. The stability of the market for Japanese government debt is well known. But it must be stressed that the cost of servicing Japan's public debt uses up half of the state's tax revenues, and the cost of importing energy after the 2011 Fukushima disaster has also negatively affected Japan's current account balance.

What of Europe?

I believe the much-overlooked problem child of the Eurozone will prove to be Italy. The third largest economy of the Eurozone is burdened by a debt ratio of 132.6%.

The ECB’s €60 billion per month quantitative easing (QE) programme has proven highly supportive for countries such as Italy and has helped to limit volatility in the Italian bond market. If the ECB were to raise rates from zero, then it is reasonable to assume that Italian short-dated financing costs would rise in tandem with spreads just as bond breadth would collapse. That would be a perfect incubator for bond volatility to flourish.

Italy has struggled to implement reforms and reduce its massive debt amid weak growth, 0.4%, so each additional percentage point that Italy must spend on debt servicing as soon as interest rates pick up again, will push up the debt ratio in the notoriously slow-growing economy, possibly fracturing an already damaged system.

Broken banking

The European banking system is riddled with non-performing loans (NPLs), and it is hardly surprising to note that there is a clear divide within the Eurozone between banks in the north and those in the south. Of the latter group, Italy presents the worst case.

Recently there has been much activity in the Italian banking system as the resolution and bail-in of Banco Popular, the bailout and transfer of the Veneto banks, and many completed NPL sales by Italian banks have caught the news headlines and attention of the ECB.

In Italy, 16 out of 19 banks have failed to meet European standards on NPLs. One must accept that the Italian second-tier banks urgently need to raise a further €32 billion of new capital to fix the gap of their loan books. This is a large amount of finance to find for what are small banks and the upshot is that further calls on Italian tax-payers and bond/equity holders look to be increasingly likely.

Remember, it is not a lack of capital that ultimately drives a bank to the wall. What is essential is access to liquidity and that totally relies on confidence. Customers will keep making deposits in a bank if they are confident they will get their money back. When confidence unwinds, the bank will totter along before its fails. 

The International Monetary Fund 's latest global financial stability report said the level of NPLs in Europe has risen to €900 billion, two-thirds located in just six Eurozone economies.

The ECB’s asset quality review has confirmed this picture, which revealed that most banks in many of these economies had high levels of nonperforming assets. The chart below illustrates how poor the prospects are for Italian banks when return on equity (ROE) is measured against NPL/total assets and recovery costs/ total assets.
Europe ROE  and NPL Source: ECB Asset Quality Review

The charts above are worrying for Europe as Italy is finding that the level of NPLs is a fetter to bank profitability. In turn, this limits the ability to create new lending to drive the real economy.
The other problem stemming from low ROE is the feedback into low productivity, high costs and overbanking. 

Only a handful of European nations countries have successfully managed these challenges. Sweden is the best example of addressing such challenges. Many other nations, particularly Italy, must take note and copy the Swedish example. Look at the Swedish position (SE) in the charts above, a position to aspire to for Italy.

If not, the mismatch on the loan and asset book will create an overnight crisis that many will say they did not see coming, and yet the writing is clearly on the wall in the shape of exposure to the property market at home and abroad, unfunded pension schemes or other toxic assets.

When the banking crisis hits home, and it will before this decade is out, one will have to wonder who will take the blame? Chances are the ECB will be far from a “BFF”.

Italian bank
 Italy's banks could be the Achilles heel. Photo: Shutterstock

— Edited by John Acher

Stephen Pope is managing partner at Spotlight Ideas

Cat Cat
Interesting read. Thank you.
fxtime fxtime
Also ECB analysis highlights a 10% strengthening of the euro purchasing power is expected to bring 0.7% reduction in eurozone economies. The euro has exceeded this level this year in part due to dollar weakening and the endless USA reality tweet/tv ''policies''.
BuySellBuySell BuySellBuySell
Good one Stephen. Thanks
Juhani Huopainen Juhani Huopainen
Also the stronger euro lowers the inflation outlook - and disinflation is not good for deleveraging / treating NPLs / the economy.
vanita vanita
Nice short note👍
vanita vanita
Means it's not rgt time to buy Dax indices.
So it's gud time to buy Nasdaq against Dax sell.
After long time happy to see you again, Take Care Steve.
Stephen Pope Stephen Pope
Dear Vanita,

Hello and I hope you are well?

Both the DAX & NASDAQ have a similar technical aspect. Short-term selling, mid-rage neutral, longer-term buying.

NASDAQ lifted by Apple in recent days & I see technology as the key driver for our future. But what may be a fetter is the lack of sense and progress in the White House. NASDAQ to improve despite President Trump...not because of him. Six months into his term, nothing to show.

In Germany, DAX will carry on in good order but German bank's are retreating into a domestic shell. Auto's are racked by emissions issues. Merkel should be re-elected in September but I think any gloss on EZ economic numbers is superficial. Banking is is a mess.

Greece played a blinder with its new debt...but if it can raise money on the open market why should it still be banked rolled by the EZ and ECB? As for Italy...that is a problem and Macron will disappoint. EURUSD at 1.18 is a reflection of how poor Trump is. Strong € is hurting. But prefer DAX.
vanita vanita
Thanks Steve for valuable comment.


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