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The Weekender

Dear All, It has been intense week of European brinksmanship. There are many clouds on the horizons and a pressing need for decisive policy actions. European and world leaders at the G8 were having largely consensual debates about the need for economic growth but came up with no deliverables. Meanwhile, deposit attrition in Greece is growing fast. Some see it or hope it could be large and brisk enoughto affect political outcomes of the June 17th election in Greece but I doubt it will and I still expect syriza to lead the polls. Its leader, Mr.Tsipras is starting a European tour with a stop in Paris on Monday and in Berlin on Tuesday. I expect his message to combine some provocation with a genuine and honest call to renegotiate the adjustment program while staying in the euro. He is also increasingly drawing parallels between his economic program and his renegotiation agenda and that of President Hollande. This parallel is potentially very slippery for France but the reality is that France is the most suitable broker of a compromise between Greece and Germany. In all this gloom, there is one piece of good news for the medium term. The IG metall deal achieved in the early morning of Saturday after a night of fierce negotiation settled for a 4.3% increase in wages over a 13 months period. This is short of the 6.5% initially demanded but is the biggest wage deal by IG metall in 20 years and is likely toset in motion similar wage increases throughout the private sector. This is good news for domestic demand and internal rebalancing. If rebalancing in theSouth is slow; that in the North is now on the move. But these considerations might well be irrelevant if financial instability takes hold. I will discuss in particular: 1. ECB, the HFSF and Greece and 2. Cyprus: the forgotten Greek drama

By: Date: May 21, 2012 Topic: Macroeconomic policy

Dear All,

It has been intense week of European brinksmanship. There are many clouds on the horizons and a pressing need for decisive policy actions. European and world leaders at the G8 were having largely consensual debates about the need for economic growth but came up with no deliverables.

Meanwhile, deposit attrition in Greece is growing fast. Some see it or hope it could be large and brisk enoughto affect political outcomes of the June 17th election in Greece but I doubt it will and I still expect syriza to lead the polls. Its leader, Mr.Tsipras is starting a European tour with a stop in Paris on Monday and in Berlin on Tuesday. I expect his message to combine some provocation with a genuine and honest call to renegotiate the adjustment program while staying in the euro. He is also increasingly drawing parallels between his economic program and his renegotiation agenda and that of President Hollande. This parallel is potentially very slippery for France but the reality is that France is the most suitable broker of a compromise between Greece and Germany.

In all this gloom, there is one piece of good news for the medium term. The IG metall deal achieved in the early morning of Saturday after a night of fierce negotiation settled for a 4.3% increase in wages over a 13 months period. This is short of the 6.5% initially demanded but is the biggest wage deal by IG metall in 20 years and is likely toset in motion similar wage increases throughout the private sector. This is good news for domestic demand and internal rebalancing. If rebalancing in theSouth is slow; that in the North is now on the move.

But these considerations might well be irrelevant if financial instability takes hold. I will discuss in particular:

1.   ECB, the HFSF and Greece

2.   Cyprus: the forgotten Greek drama

ECB, the HFSF and Greece

The ECB has created a lot of confusion last week by announcing the suspension of Greek banks from its refinancing operations. In the current context of growing concerns over a possible exit from the euro area, this move unfortunately validated a number of concerns.

The decision was very poorly communicated and deserves some background explanation.Over the last few months, the troika and the Greek authorities have spent time debating the shape and form of the Greek banks recapitalization program. Little has been achieved in so far as restructuring is concerned (ie. there is a blanket recapitalization exercise with minimal restructuring of deficient institutions apart from two small banks) and there were two major disagreements:

  • One between the ECB and the EFSF as the EFSF was reluctant for the Hellenic Fund for Financial Stability (HFSF) to recapitalize the banks with direct equity and favoured alternative options such as contingent capital and loans in order togive more protection to the EFSF. This disagreement was dealt with late in 2011as the ECB imposed capital injection and forced the hand of the EFSF.
  • The second disagreement was among Greek authorities. Papandreou and the Bank of Greece favoured investments in common equity, which would involve a controlling stake in private banks by the government and would effectively equate nationalization with the possibility to removing and replacing the existing management. This was very appealing to Papandreou for obvious political reasonsand for the Bank of Greece who would have effectively taken control of the banking system.

Yet the ECB, disliked the “common equity” option and favoured “preferred equity” investments, which would allow banks to retain their management and be run privately. The deal was also structured such that banks needed to raise about 10% of their capital needs privately in order to force banks to leverage public resources with more private capital. If they failed to raise the 10% requested, banks would be forced to accept common equity injections that dilute shareholders and risk a loss of control.

PM Papademos argued in favour of this option with the support of the ECB but implementation was slow and then effectively frozen by the Bank of Greece andthe HFSF prior to the elections. The ECB then gave 1 month to the authorities to implement the agreed decision and proceed with the recapitalization. This deadline passed last week.

After the ECB announcement last week, a deal was found in emergency and the banks will be recapitalized this week along the “Papademos plan” so that they retain their access to the ECB’s refinancing operations.

This exercise creates all sorts of doubts and questions about the ECB’s actual willingness to shut Greece off the eurosystem but more importantly, it also highlights the incredibly erratic banks restructuring process and calls foronce and for all for a proper restructuring mechanism that obliges memberstates regardless of whether they are in a program or not. This restructuring authority would save European taxpayers, money and time and would be a major contribution to financial stability.

In fact, at this stage, this is probably the single most important thing that European policymakers can do to reduce financial distress and reduce downside risks to short-term growth. Making steps towards a banking union should be at the top of the Agenda for European Council of June and the informal dinner of May 23rd.

Cyprus: the forgotten Greek drama

The crisis in Cyprus has been largely ignored so far while it raises important policy challenges. Some of these challenges are the simple reflection of Greece’s own difficulties but others are truly idiosyncratic.

At the end of 2011, Russia discussed a 5bn euro loans to Cyprus so that it avoided seeking EFSF assistance. The deal was eventually scaled down and signed for 2.5bn euros in December 2011. Some 590 millions were disbursed in December 2011,it received another tranche of some 1.3bn in January 2012.

Meanwhile, the situation has continued to deteriorate. Last week, the government was forced to agree a 1.8bn euros or close to 10% of GDP capital injection in Popular Bank. But there might yet more to come if the situation in Greece deteriorates and/or there is more deposit runs.

Indeed, the scale of the recourse to ELA has increased substantially and is now north of 5bn euros. Interestingly, Cypriot banks have limited dependence on wholesale funding, which limits the risks on the liability side of their balance sheet to their shareholders and depositors who for now have showed remarkable nerves (deposits from residents and non-residents are virtually unchanged).

If the stability of deposits starts to be threatened, the banking system will beeven more challenged than it currently is. A banking system that is heavily deposits financed doesn’t face wholesale refinancing rollover risks but theshort duration of its liabilities can make it extremely fragile.

Only a small portion of these deposits (8.2%) is coming from other euro area countries. Yet, a credible deposit guarantee scheme would most definitely contribute to stabilize the banking system and avoid precipitous deposit flight. The Cypriot example is yet another illustration of the incompleteness and the need for a real banking union. If Greece, Spain and Ireland illustrate the need for a resolution framework, Cyprus is the prime example of a banking system that requires a functioning and credible banking pan European deposit scheme.

Happy to have your thoughts as usual,

Best Regards,

Shahin Vallée


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