Friday, January 20, 2012

Mario Draghi: Europe's master of illusion....

Mario Draghi: Europe's master of illusion....
By Chan Akya

We may only be a couple of trading weeks into the calendar year, but the competition for the Man of the Year for 2012 may already be over. With a breathtaking display of chutzpah and impossible acts of bravado befitting an alumnus of Goldman Sachs, the new president of the European Central Bank (ECB), Mario Draghi, may already have saved the eurozone and with it, the global economy.

For that is what both the bond and equity markets are telling us, now that a series of bond issues in Europe have gone very well, with even bankrupt Spain raising new money for less than 5% this week.

The proximate cause of this would be the ECB three-year loans to European banks (which attracted over 489 billion euros, or over US$600 billion, of demand in December) and a second tranche next month is expected to dole out another 400 billion euros in long-term liquidity to European banks who are unable to borrow in the markets.

The flood of liquidity engineered by the ECB has more than offset any investor concerns arising from a set of dreaded set of credit rating cuts engineered by S&P (including the much-prized triple-A rating of France).

Amidst the euphoria, readers are requested not to exercise their grey matter too heavily. For example, now is most certainly not the time to consider the moral hazard entailed by lending Italian banks three-year money at a rate of 1% at a time when sovereigns of the same countries were borrowing at over 7% (when they could find the money, that is).

It also shouldn't attract any scrutiny at all that European banks have a severe shortage of capital, so in effect the ECB was (and will be again) printing money to lend to folks who weren't all that thrilled to be lending to each other. So much so that when the banks got the money from the ECB, they all went and lent it back to the central bank at 0.25%.

That's right - the ECB was so successful that the banks decided to take a negative net interest margin of 0.75% with the money they got. Even a few weeks later, a good 400 billion euros still sit with the ECB overnight from the banks rather than being on-lent to the "real" economy.

No one should tell all those suddenly bullish folks that even the European banks' industry body (the EBA) advises banks to raise their capital levels to over 9% by the middle of this year, which can only be achieved by selling good assets quickly (at discounted prices). That's why the banks are hoarding liquidity even as the new credit crunch will push the European economy into a severe contraction by the second quarter of this year.

No really, no one tell them all these facts.

Then there are the European sovereigns. They have been roundly downgraded, and things aren't getting better anytime soon. There is a chance Greece will yet slip into a disorderly default even as everyone attempts to get a face-saving deal that will see creditors recover barely 30% from the country's debts.

Even at that horrendous discount (a "haircut" as it is cutely referred to in the debt markets for what looks more like a decapitation) it is not clear that Greece will have a sustainable debt load. Indeed, recent reports of net emigration from Greece are troubling enough for even Europeans (not generally known for their economic or financial prudence) to want to downgrade forecasts for debt reduction and long-term prospects.

Italian banks benefited from the munificence of Mr Draghi - who took office barely two months ago - to the tune of 50 billion euros, burnishing his chances of becoming a prime minister of the country in future (you read it here first). They have also taken his message to heart and fully supported Italian government bond auctions - before quickly selling on to unsuspecting retail investors of usual.....

The government of Brussels-appointed technocrat Prime Minister Mario Monti has made some cosmetic reforms, but doesn't quite seem to have any handle on reducing debt or indeed even cutting the deficit meaningfully. Mr Monti is quickly forgiven for his lack of success, unlike his predecessor, Silvio Berlusconi.

How long does a honeymoon last these days in the debt markets, anyway? Oops, sorry that was another unintended question for the market honeymooners....

Do I even need to bring up Spain? Its economy is not only too big to rescue, but also too difficult to handle, what with rampant property market declines, failing banks, collapsing consumption and rising emigration.

Then there is Portugal, whose credit spreads have quietly gone wider through this week's euphoria as market participants quietly line up their next target after Greece. With over 275 billion euros in debt that needs to absorbed over the medium-term, Portugal will be doing the equivalent of wrestling with a 900 pound gorilla for a market that failed to come to grips with the 50 pound monkey that was Greece. I really didn't mean to put in a reality check here, honest.

Meanwhile, the World Bank warned developing countries that their growth projections were seriously off kilter; that falling consumption in the Group of 10 countries would hit their exports sharply just as rising commodity and other prices were pushing their central banks to raise rates and hamper consumption growth at home. That these economies were meant to supply the necessary funds to absorb all the excesses of G-10 is a minor detail at this stage. Of course.

Did I forget to mention that the chief reason for the market's euphoria earlier this week pertained to International Monetary Fund plans for a $500 billion boost to its fighting fund. One-time only offer, you understand. This was duly subscribed to by such fiscally conservative governments as the United States, Britain, Japan and the "top" tier of Europe. That every one of these countries will have to borrow from private markets immediately to fund this allocation is, of course, of no immediate concern to anyone in the markets....

All in all, right there is the reason why Mr Draghi is already the Man of the Year. By creating a masterful illusion of stability, he has sent global equity markets packing to their 15-year highs (January returns). Mere facts will do nothing to derail such a rally, which is what makes it truly a remarkable piece of work by the Mafiosi ECB president....

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