Thursday, September 20, 2018

The ECB And Draghi Are Starting To Grasp At Straws

While much of the world is focused on trade wars when looking at the future value of the Euro it is important to keep in mind several key elements of "currency relativity." Bloomberg recently suggested that most likely the ECB’s economic forecasts projections would be downgraded and the ECB has confirmed this. The forecast has been adjusted lower cutting 2018 and 2019 GDP from 2.1% and 1.9% to 2.0% and 1.8%, respectively Draghi assessed that the expansion is "still solid" while noting that "uncertainty around the inflation outlook is receding." This comes at an important time for the Governing Council of the ECB which was thought to be prepared to marginally wind back stimulus.

Euro Leaps Higher Against Dollar As Draghi Talked
The concession that growth is slowing dampens the excitement of those that have been warning us we were about to be in for a hawkish surprise. Surprisingly the spin on lower growth caused the euro not to leap higher because Draghi also stated the ECB projects "significantly stronger core inflation." Apparently, this coupled with the latest miss in U.S. inflation as CPI  came in lower than expected added fuel to the spike. The mood was also boosted by Draghi's positives comments regarding the fact that so far all the major Italian ministers and the PM have said they will respect the EU’s budgetary requirements.

As of yet problems in Italy have been contained and have not had much effect on Europe. Italy with its newly-installed government has started taking an increasingly conciliatory tone with regards to their budgetary intentions. Despite this seemingly new approach from the populists, eventually, a clash between Italy and the EU seems inevitable. Such a clash would elevate grave concerns over Italy’s fiscal discipline and heightened fears over the nation’s intentions of paying debt held at the ECB. While people would like to probe Draghi on his views on the matter and what mechanisms the Bank has to counter any potential Italian crisis, this is a subject Draghi will most likely avoid by being nonspecific and referring to the general rules already in place.

Year After Year Of Little Growth (click to enlarge)

For years the Euro-zone has enjoyed a solid trade surplus from its dealings with America. It is pure folly if they think realigning the Euro-zone with China will result in the same kind of beneficial relationship. To make matters worse, it could be argued that the meager growth the Euro-zone experienced has come mainly from two areas and is neither balanced or has much further potential. Some of it has resulted from the influx of shall we say, "mainly unwanted" immigrates flowing into the area that needed to be housed and fed. And much of the rest from ECB stimulus. This slowing has occurred as the euro area trade surplus declined to the lowest level in four years in July, exports dropped 0.8 percent month-on-month, while imports grew 1.3 percent. Figures from Eurostat show the trade surplus fell to a seasonally adjusted EUR 12.76 billion from EUR 16.47 billion in June. This was the lowest since June 2014, when the surplus totaled EUR 12.22 billion.

The reality is that after years of doing "What Ever It Takes" Draghi must about be at wit's end. Draghi became the focus of the world at a speech in London on July 26, 2012, when the ECB President gave an account of the euro-zone economy as bond yields of weak euro-member governments were soaring. At the time many traders held grave doubts that EU-level institutions could get their act together in time to avert disaster. In the historic speech Mario Draghi pledged to do "whatever it takes" to protect the Euro-zone from collapse, this included fighting unreasonably high government borrowing costs. As Draghi sought to convince international investors that the region’s economy wasn’t as bad as it seemed. He then made the momentous remark:
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
While the ECB might have sidestepped the collapse of the euro over recent years many of us skeptics believe it will ultimately result in a major devaluation of the euro with devastating side-effects for those holding the currency. The title to this piece referring to the ECB "grasping at straws" alludes to the idea no real solutions exist for the Euro-zone as it confronts the grueling challenges before it of remaining competitive in the global marketplace while a critical currency problem brews within its mist. Much of this relates back to the flawed way the euro was created and its failure to become a "truly unified" economic union. Draghi's stand continues to be that the euro is indispensable and is strong, because societies want it and that it is in no one’s interest to doubt its continued existence and even discussing its abolition is harmful.

This year six Euro-zone countries may break the European Union’s budget deficit rules which probably gives them little room to help by expanding spending. Belgium, Italy, Austria, Portugal and Slovenia, the Draft Budgetary Plans (DBP) pose a risk of noncompliance with the requirements for 2018 with France falling upon the same problem. The rules say that EU countries should have budget deficits below 3 percent of GDP and public debt below 60 percent of GDP. Italy, which has the second highest debt in the EU after Greece at more than 130 percent of GDP, to voice concern was singled out as particularly troubling.

John Mauldin, chairman of Mauldin Economics, thinks the flashpoint for the next crisis is likely to be in Europe, especially Italy and the choice of Europe in coming to terms with whether to put a lot of bad debt on the balance sheet of the European Central Bank or deal with defaults and the contagion that flows from them. If not addressed the Euro-zone breaks apart and we’re going to get a 50% valuation collapse. “Greece,” he said, “is a rounding error. Italy is not" This means Brussels and Germany are going to have to allow Italy to overshoot their persistent debt, and the ECB is going to have to buy that debt. It seems that until now, a program known as "Target 2" has been the salvation of the euro and responsible for preventing countries from collapsing.

Since 2015 we have been again witnessed capital fleeing to the north as a result of Draghi starting QE in 2015 and the Bundesbank starting to buy back bonds on the market. The Italian central bank is dependent on the ECB and has to buy Italian government bonds. German investors have to exchange these bonds for euros in Italy and transfer the money via Target 2 to their German bank. The growing differences in the Target 2 balance sheet is the result of the Germans, who own the Italian bonds dissolving them in Italy and transferring the money to Germany. Italians have also added to the capital flight as they liquidate their bonds and send their money abroad. This translates into enormously huge debt claims on the German side where this year they have already reached a trillion euros which is about 25% of German GDP. 

These German Target 2 claims are not covered by any securities. If Italy or Spain withdraw from the Euro-zone, the Germans will be left holding worthless paper. This has not generated much unrest in Germany only because the Germany people have great confidence in the Bundesbank. At a press conference on 26 July this year, Draghi said about Target 2: “It has nothing to do with the movement of capital from country to country” and the clearing balances cannot be overdrawn as long as no one leaves the Euro-zone. This translates into, Italy must not leave the Euro-zone! Italy's debt amounts to 2.3 trillion euros and its liabilities in Target 2 rose in June 2018 to 481 billion euros from 164.5 billion euros in 2015. This means that Banca d’Italia owes the Bundesbank almost half a trillion euros!

So, we have Draghi, the Italian who uses his position to save his country, and on the other, there are many German economists who criticize Target 2 and see it as a check that cannot be cashed. Still, the slowing of the Euro-zone economy means the ECB appears once again to be on auto-pilot and has postponed the idea of raising rates until other central banks raise theirs the ECB is safe hiding in plain sight but if the Fed moves even a bit higher all bets are off. Weakness in the euro almost certainly will result in a stronger dollar which could be the catalyst for the emerging market crisis to spread to the rest of the developed world and evolve into a global deleveraging event. Again it is difficult to ignore the fact the euro remains very vulnerable.

Footnote; While like all fiat money the dollar is nothing to brag about at this time the other options are even less compelling. When placing a value on a currency we are talking about "relative value." The argument that currencies are trading in a false paradigm extends past simple manipulation and is bolstered by their being sheltered from the storm of volatility by existing in a rather closed system in which wealth tends to become trapped. The article below argues that it is to early to count the dollar out because of its status as the worlds largest reserve currency by which all others are judged.

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