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European Debt Crisis

German endgame in sight? Mitteleuropa and the grosse Deutsche mark


Markets tumbled again this morning on news of new lows in German business confidence as well as terrible news from some of Europe’s biggest banks:

  •  Unicredit SpA, Italy’s largest bank, posted a historic loss of €10.6 billion, mostly on a one-time write-offs of impaired investments and goodwill. However, even excluding the one-time items, the quarterly loss was of  €474 million. Unicredit also announced a plan to lay-off 7,400 workers in Europe by 2015 and to close the Western European brokerage business. The share price fell 6%; (1)


  • Credit Suisse was threatened with a ratings downgrade by Moody’s after news of a loss in the investment banking business and poorer than expected results in the wealth management division. Credit Suisse has also been under scrutiny by German and US tax authorities; (2)


  • Over the weekend, Christian Clausen, the president of the European Banking Federation, stated that banks should keep dumping Italian bonds in order to “move out of the epicenter”. (3) European banks appear ready to divest themselves of more than €300 billion in Itailan bonds (4) which would make the ECB’s job of supporting Italian bond prices even more difficult.

As one would expect, spreads for Italian bonds began to climb again after dropping over the weekend with the resignation of Silvio Berlusconi and his replacement by Mario Monti, a technocrat. This is not a surprise: it is the consistent pattern of the past year. European leaders issue a statement or declaration of intent, the markets rise, then rapidly sober up to the truth of the underlying fundamentals.

Italian 10-year bond benchmark:                                                         Spanish 10-year bond benchmark:









Spain also faces an important test this week with bond issues on the 15th and 17th of November. The earlier issue is for 12- and 18-month notes with a face value between € 2.5 and €3.5 billion. On the 17th, the Spanish Treasury will attempt to sell between €3 and €4 billion in 10-year notes. These risk premium on these two issues will be critical for Spain’s credibility and access to international capital markets.

Throughout the hammering that bond markets have been undergoing for the past months, another chart shows a curious trend:











The Euro:Dollar exchange rate shows remarkable stability for currency that seems on the verge of dissolution. In fact, the Euro remains slightly above it’s average for the year, despite the woes of Europe’s periphery and the likelihood of a recession. Are currency traders are dumb, or bond traders for that matter?

My guess is that neither is true; and that, in fact, both the currency market and the bond market are right. The bond markets are telling us that Greece, Portugal, Ireland, Italy and Spain are all going to default. The currency markets suggest that the euro will remain strong vís-a-vís other hard currencies due to the underlying strength of the German economy and strict monetary policies inherited from the Bundesbank. These two stories are reconciled by an ejection of the periphery from the single currency, which will become essentially a “grosse Deutsche Mark”.

There are more than a few indications that this option is in the works. Nicolas Sarkozy and Angela Merkel have both floated the idea of a “two speed Europe” (Mr. Sarkozy on 8 November and Fr. Merkel on the following day). Both were quick to deny that this could possibly mean that any nation would be forced out of the Euro. Of course, just 6 months ago, both leaders categorically denied the possibility of a Greek default.

The most critical political indicators begin to accumulate witha  disheartening rapidity:

  • The German government and the Bundesbank, which has one vote on the ECB board, like the other 16 member states including troubled Greece, Italy and tiny Malta, are warning that the European Central Bank is straying from this core task.  Two German members of the ECB board have left this year in disgust at the bond-buying strategy. Bundesbank chief Jens Weidmann blocked attempts at the G20 summit to make further inroads into central bank independence by purloining Bundesbank gold and currency reserves to boost euro zone bailout funds.  “Bundesbank prevents trickery by euro partners,” was how the top-selling news magazine Der Spiegel hailed Weidmann’s stand. (5);
  • On top of that, Merkel’s CDU party voted yesterday to allow euro states to quit the currency, a move not currently allowed to members. While party spokesmen denied that they were “throwing anyone out” it is hard to conceive what other purpose such a measure could have. The only question is whether the exit is voluntary or involuntary. As the Germans will write the rules, it is safe to assume that they will be written so as to force an exit of “non-compliant” periphery members. (6);
  • The “technocrats” who have been hailed as the “solution” to the political embarassment that were Papandreou and Berlusconi are already facing serious revolts from their respective parliaments. The Greek right has said that it rejects more austerity measures that will only deepen the suffering of the Greek people and economy and Papademus must face a confidence vote on the 16 Nov – which, if he fails to survive it, will hit European markets like a bomb. Monti is also facing serious opposition from the Italian parliament, with Northern League members threatening outright secession (always something of a dream for them). It is difficult to believe that either nation will be able to force through and implement the large scale austerity measures that will be required of them this year and next; it is even more difficult to believe that these austerity measures will do anything but deepen the economic recession in these countries and make it even more difficult for them to pay back the interest they owe or outgrow their outstanding debt. (7);
  • The situation in Spain and Portugal is slightly different, with a new conservative government almost certain to win an absolute majority in the former country, and a conservative government already in place in the latter. Even so, Spain is a nation of 5 million unemployed (23% of the workforce) with an economy that did not grow at all in 3Q2011. How much more austerity can the central government impose without risking the wide-spread public disturbances already cropping up in Portugal? (8);
  • On 10 November, S&P “accidentally” downgraded France’s credit rating, the effects of which would be so disastrous as to be tantamount to throwing in the towel on the Euro (this is because France is one of the main contributors to the EFSF which would be used to “bail out”  weaker members…if France is seen to be unable to meet those commitments, the EFSF goes down the toilet). While S&P was quick to deny the report, leaving the French fuming, does anyone doubt that this is a clear warning to the French Republic that her financial house is in disorder? (9);
  • Adding to French gloom, Moody’s warned that France was the weakest of the AAA rated countries and that they would review their rating in three months. The Lisbon Council today issued their 2011 Euro Plus Monitor report echoing these concerns on French finances (10). In their assessment, they state that France is: “By far the least healthy of the AAA-rated eurozone members. A country full of potential that needs to be unlocked through labour market reforms, some product market deregulation and a trimming of the public sector to shift more resources into export-oriented activities.” At the same time, Dutch, French, Finnish and Austrian bond spreads have begun to diverge from the “safe haven” of German bonds. Especially the last three, which are rapidly approaching their maximum divergence of the past year. All were considered relatively immune to “contagion” from the periphery, but this assumption now seems less sure.

European leaders meet again on 9 December. I expect that Angela Merkel, with the previously negotiated agreement of France’s Sarkozy, will show up at the conference with two briefcases. In briefcase #1, there will be a rough draft of a revised Lisbon Treaty, incorporating all of the fiscal and regulatory changes the Germans are clammoring for. There will be new austerity measures demanded; closer fiscal union; punitive fines and EU oversight for delinquent euro members; and an exit mechanism for states that can’t or won’t play ball. Mrs. Merkel will attempt to strong-arm the “Club Med” to gain their quick ratification of the treaty changes, because she knows that there is very little time left if the euro is to be saved.

In briefcase #2, is the proposal to form a new eurozone that includes Germany, France, Belgium, the Netherlands, Austria, Finland and a few other “responsible members”. These nations will agree to closer fiscal union; punitive fines and EU oversight for delinquent euro members; and an exit mechanism for states that can’t or won’t play ball. The other members will be ejected.

In the briefcase #2 scenario, events would move with lightening speed. That’s a subject for another post, however. Suffice it to say, that briefcase #2 is no longer unthinkable. Goldman Sachs has estimated the exposure of Germany and France to the sovereign debt of the peripherals at €84.5 and €54.5 billion respectively (14 July 2011). These are not insignificant numbers, but certainly within the means of each country should they decide to stop trying to fill the moneypit that is Southern Europe and instead to pay it out to insulate their own financial systems from the damage of multiple exits from the euro.

The rest of “Mitteleuropa” would go along for similar reasons – the direct cost of insulating their banks is rapidly becoming less than the endless contributions to bail-outs and rescue funds. For France, itself straddling the Mediterranean and Atlantic cultures, the risk of being lumped in with the “poor South” and the cost of losing their AAA credit rating may be too much to bear. In any case, for geo-strategic as well as economic reasons, France must move with Germany.

The euro has perhaps three months of life left. Unless Germany caves in to demands to allow the ECB to become a lender of last resort, or Southern Europe agrees to a renunciation of fiscal and monetary authority to Northern Europe, then we will see the creation of a new “fast track” Europe centered on Germany and Mitteleuropa.

NOTE: As I was writing this post, the Spanish Treasury managed to place € 3.16 billion out of a maximum issue of €3.5 billion in 12- and 18-month notes during today’s sale, but at a higher than expected (or desired) rate. The 18-month paper sold at 5.159%, up from 3.801% just last month. The 10-year bond price is also up in advance of Thursday sale at 6.28%, up from an average of 5.25% last month.


1 http://www.bloomberg.com/news/2011-11-14/unicredit-rights-issue-to-total-as-much-as-7-5-billion-euros.html
2 http://www.bloomberg.com/news/2011-11-14/credit-suisse-rating-under-review-by-moody-s.html
3 http://www.bloomberg.com/news/2011-11-13/europe-s-banks-should-keep-dumping-italian-bonds-to-cut-risk-clausen-says.html
4 http://www.ifre.com/banks-to-dump-more-italian-debt/1615206.article
5 http://www.reuters.com/article/2011/11/10/eurozone-germany-history-idUSL5E7MA17O20111110
6 http://www.bloomberg.com/news/2011-11-11/german-cdu-is-set-to-back-motion-allowing-euro-member-exit-1-.html
7 http://www.reuters.com/article/2011/11/14/us-eurozone-idUSTRE7AC15K20111114
8 http://www.reuters.com/article/2011/11/14/portugal-gdp-idUSL5E7ME1M120111114
9 http://www.bbc.co.uk/news/business-15686580
10 http://www.lisboncouncil.net/publication/publication/68-the-2011-euro-plus-monitor.html

Additional Charts:

French 10-year bond benchmark:







Dutch 10-year bond benchmark:






Austrian 10-year bond benchmark:






Finnish 10-year bond benchmark:

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