Monday, March 11, 2019

Euro-zone Banking Deception Continues Unabated

Source: ECB, Federal Reserve Bank of St. Louis.
To say the Euro-zone banking system deception is continuing understates the size of the fraud occurring before our eyes. In many ways, it has been allowed to continue only because other central banks and financial institutions fear that shining a spotlight upon it would undermine world currency markets and bring about a collapse in confidence. It is becoming clear the euro has no path out of this mess. The chart to the right speaks volumes as to the size of this charade.

A huge problem before the region is envisioning exactly from where its next economic renaissance might flow. The source certainly won't be from a well tuned and responsive political system or because of its growing ability to produce goods for a fraction of the cost of competing nations. Unfortunately for the Euro-zone, much of its problem can be viewed as one of "stagnation." Figures show that as of 2017 not a single European company ranked among the top fifteen technology companies in the world. It was mainly North American and Chinese companies that are driving the world forward. Still, more troubling is that of the top 50 global technology companies, only four are European and even those are slowing losing their edge.

Challenged and crippled by political instability, cursed by a lack of political cohesion and strikes, many countries within the zone are struggling just to continue functioning on a day to day basis yet move forward economically. In France Marcon remains under attack from the yellow vest movement which has now disrupted business and impacted tourism for several months. In Italy where its massive national debt adds to the unfolding political drama, many issues remain unsettled. Also, there is the issue of Brexit and the possibility the United Kingdom (UK) may just walk from an unbending European Union and simply let the chips fall where they may.

All this raises the question of not if but when the value of the euro will begin to show the stress which has been masked-over and greatly ignored until now. I tend to agree with John Mauldin, chairman of Mauldin Economics, he thinks the flashpoint for the next crisis is likely to be in Europe, with much of the focus on Italy. The choice of Europe is 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" The bottom-line is Brussels and Germany are going to have to continue buying Italy's 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 are 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 that 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 2017, 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!

To be perfectly clear, there are many German economists who criticize Target 2 and see it as a check that cannot be cashed. This coupled with the slowing of the Euro-zone economy means the ECB appears once again to be on auto-pilot as Draghi recently announced a new round of long-term loans to banks and promised interest rates won’t be lifted from record lows until 2020. The ECB is safe for now hiding in plain sight even as the ECB president prepares to leave office in October after spending his entire eight-year tenure crisis-fighting. Still, 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.

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  1. Bruce...I have been reading you for years and you seem to have your global picture in focus but rarely get comments on your work. Can you shed some light on the reason for that?

  2. I've commented on several of Bruce's very interesting and very informative articles. Bruce is one of the best commentators out there, I think.