Earlier this month, Spain began “rocking” the EU boat by telling the EU it wasn’t going to meet the new EU fiscal requirements.
Spain’s sovereign thunderclap and the end of Merkel’s Europe
As many readers will already have seen, Premier Mariano Rajoy has refused point blank to comply with the austerity demands of the European Commission and the European Council (hijacked by Merkozy).
Taking what he called a “sovereign decision”, he simply announced that he intends to ignore the EU deficit target of 4.4pc of GDP for this year, setting his own target of 5.8pc instead (down from 8.5pc in 2011).
In the twenty years or so that I have been following EU affairs closely, I cannot remember such a bold and open act of defiance by any state. Usually such matters are fudged. Countries stretch the line, but do not actually cross it.
With condign symbolism, Mr Rajoy dropped his bombshell in Brussels after the EU summit, without first notifying the commission or fellow EU leaders. Indeed, he seemed to relish the fact that he was tearing up the rule book and disavowing the whole EU machinery of budgetary control.
Spain ultimately acquiesced here once the EU permitted it to meet more lax requirements. However, this was a definite warning shot from a BIG PROBLEM country for the EU.
As I’ve noted before, Spain must be watching what’s happening in Greece and asking itself whether it wants to go through this whole process of negotiating for bailouts via austerity measures.
Indeed, Spain’s economy is already disastrous. Unemployment is already 20+% without any major austerity measures having been put in place. Anecdotal reports show Spain to be an absolute disaster. Spanish banks GREATLY underplay their exposure to the Spanish housing market (“officially” prices are down 20% but most likely it’s a lot more than that).
Put another way, Spain in many ways, Spain is already in as bad a shape as Greece. And it hasn’t begun any significant austerity measures yet. Having seen what austerity has done to Greece (Greek GDP shrank 6.8% in 2011 AFTER Greece received bailouts equal to 57% of its GDP), Spain is much less likely to opt for the bailout/ austerity measure program.
The significance of this is HUGE. According to the Bank of International Settlements worldwide exposure to Spain is north of $1 TRILLION with Great Britain on the hook for $51 billion, the US on the hook for $187 billion, France on the hook for $224 billion and Germany on the hook for a whopping $244 billion.
However, as I have proven in previous issues, the Bank of International Settlements’ estimates actually underestimate the true exposure EU nations pose to the financial system (for instance, the Bank of International Settlements claims German exposure to Greece is only $3.9 billion… when Germany’s Deutsche Bank alone has over 2.8 BILLION Euros’ worth of exposure to Greek debt and businesses). And Germany has TENS of other banks with exposure to Greece besides Deutsche Bank.
So it is safe to assume that global exposure to Spain is well north of $1 trillion. So if Spain chooses in any way to stage a default/ messy debt restructuring, we’re going to see:
1) A systemic crisis that would make Lehman look like a joke
2) The breaking up of the EU
3) A bear market in bonds (which we have not seen in roughly 30 years)
Germany, the de facto bailout member of the EU, is most certainly aware of this Spain’s situation. Indeed, Germany is showing more and more displeasures with the ECB.
Rift Grows Between Germany’s Bundesbank and ECB
There is a rift among top-ranking officials at the ECB, and it also extends between the majority of the ECB’s Governing Council and the Bundesbank. First, two leading German ECB officials — chief economist Jürgen Stark and Bundesbank President Axel Weber — resigned because the monetary authority was buying up sovereign bonds from Greece and Portugal. Then Weber’s successor Weidmann objected to the ECB’s purchase of government bonds from heavily indebted Italy.
Now, Weidmann is rebelling against the manner in which Draghi is giving European banks one new cash injection after another. Although Weidmann admits that the measures are basically correct, their conditions are “very generous,” he complains — and expresses his total opposition to this policy in the jargon of the central bankers: “This can particularly become a problem if banks are discouraged from taking action to restructure their balance sheets and strengthen their capital base.”
Last week, the conflict escalated to a new level. Weidmann complained in a letter to ECB President Draghi that the central bank was accepting increasingly lower-grade collateral in exchange for its cash injections. This poses a danger, he warned, as the central banks in the north of the euro zone are owed ever growing amounts of money by their counterparts in the south. If the euro zone broke apart, the Bundesbank would be left holding a good deal of its bad debt from so-called TARGET2 loans, which currently amount to some €500 billion ($660 billion), he warned.
This may sound somewhat technical to most laypeople, but among leading ECB officials the letter was seen as violating a taboo. TARGET2 refers to the central banks’ internal payment system, which has accumulated massive imbalances during the course of the euro crisis. These inequalities aren’t problematic as long as the monetary union remains intact. So far, the Bundesbank has always played down this risk. But Weidmann’s about-face is a “disastrous signal,” say ECB executives because, for the first time ever, the Bundesbank “is no longer ruling out a break-up of the euro zone.”
http://www.spiegel.de/international/germany/0,1518,819255,00.html
Weidmann has every reason to be nervous about the ECB’s actions. Thanks to the ECB’s LTRO 1 and LTRO 2 schemes, the ECB’s balance sheet is now over €3 trillion in size (larger than Germany’s economy and roughly 1/3 the size of the ENTIRE EU’s GDP). Aside from the inflationary and systemic risks this poses (the ECB is now leveraged at over 36 to 1), Germany has a very specific concern regarding the ECB’s actions:
ECB Balance Sheet Jumps Above €3 Trillion
The mix of bond purchases and loans has exposed the ECB and the 17 national central banks that make up the euro to losses in the event of defaults or bank failures. Last month, the ECB was forced to swap its €50 billion Greek bond portfolio for new bonds to shield the banks from potential losses in the event of any forced write-downs.
If banks that have borrowed from the ECB can’t pay the money back and the collateral they have posted falls in value or becomes worthless, the ECB would be on the hook for losses. Most of these losses would be spread across national central banks according to their size, meaning Germany’s Bundesbank would face the largest exposure.
http://online.wsj.com/article/SB10001424052970203458604577265373668388122.html?mod=googlenews_wsj
I’ve noted before that Germany is preparing to leave the Euro. With Spain now openly defying the EU and the ECB shifting the potential losses from its actions onto Germany’s shoulders, the likelihood of Germany walking out of the Euro has greatly risen.
And Germany is ready to go if it needs to. Remember as I’ve noted in previous articles, Germany has just put a firewall around its banking system by re-instating its SoFFIN emergency bailout fund. As a quick refresher, the SoFFIN has:
1) €400 billion in guarantees to prop up German banks
2) €80 billion to help German banks recapitalize themselves
3) The authority to let German banks dump their euro-zone government bonds.
http://online.wsj.com/article/SB10001424052970204573704577184362262410868.html?mod=googlenews_wsj
These actions, taken in the context of the fact that Germany refuses to provide any additional capital to the EU’s EFSF mega-bailout fund, make it clear just where Germany’s priorities lie: with Germany NOT with Europe.
This situation needs to be watched VERY carefully. Greece is no longer important, you need to keep your eyes on Spain and on Germany: the former in terms of how it chooses to proceed regarding potential bailouts, the latter in terms of how it reacts to the ECB and Spain.
If Spain doesn’t opt for austerity measures in return for bailouts, the EU collapses. If Spain does opt for austerity measures in return for bailouts, it’s quite possible Germany will bail on the EU.
If either of these happen, we’re going to see a Crisis that’s worse than 2008.
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Chief Market Strategist
