by Alasdair Macleod, GoldMoney:
In these dogdays of summer, there is a new complacency over the financial and economic status of the Eurozone. Inflation is down, bank shares have rallied, and the end of further rises in interest rates is in sight.
The lull in bad news conceals a deteriorating situation. In common with other markets, Eurozone bond yields are rising, and banks are now visibly trying to reduce their excessive balance sheet leverage. This is bound to lead to credit shortages in the coming months, maintaining or even driving interest rates higher. Contracting credit could lead to funding dislocations for highly indebted Eurozone governments, all mired in debt traps.
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Presiding over all this is a clueless ECB, long on rhetoric and short on economic nous. Furthermore, even though it has reduced its balance sheet by a trillion euros, the hidden losses in the euro system wipes out its equity many times over. How can it recapitalise itself, and how can it underwrite depositors in a deteriorating commercial banking system?
It is a recipe for an entire systemic failure.
Definitions: The Eurozone is comprised of the European nations which have adopted the euro as their currency. The euro system is the combined network of central banks, comprising the ECB itself and the national central banks.
Introduction
There is good news on the inflation front for some countries in the Eurozone. CPI inflation in Spain is back down at 2.9%, in Germany it has dropped to 6.1% from 7.2% in April, and in France it is down to 5.6%. Annual rates are falling, mainly because large price rises are dropping out of the back end of the statistics. But with energy prices easing substantially (natural gas is down 74% year-on-year, and heating oil down 44% both in dollar terms) mainstream economists are increasingly confident that the declining trend will continue, and that the inflation monster has been slain.
Instead, their concerns are now more about the prospect of recession, with hopes for a decline in interest rates now that inflation is becoming yesterday’s story. In this context, many are looking at money supply. And in Q1 this year, Eurozone M3 has contracted by a paltry €140bn since last September to a little over €16 trillion. But in another statistic, the euro system’s network comprising the ECB and national central banks has reduced its collective balance sheet by a little over €1 trillion over the same timescale.
Therefore, monetary tightening has been at the central bank level, reducing holdings of euro area government bonds, and reducing commercial bank assets accordingly. Balance sheet contraction has not been much at the expense of bank deposits, which are the largest component of broad money supply M3 statistics. Instead, the banks collectively will have reduced other liabilities, at the “wholesale level” by which we mean repo and interbank markets and other sources of funding to match the reduction in their reserves in the euro system.
Monetary economists point out that adjusted by CPI inflation, real money supply is contracting severely. Their common view is that the slowing down of monetary growth is a clear indication of interest rate overkill, leading to a recession. They are correct in this conclusion, but not necessarily for any reason other than the empirical evidence that they cite. The reason this is correct is that nominal GDP is simply the sum total of eligible transactions over a defined period recorded in the statistic. Bank credit measured by deposits is the stock of currency and credit for all economic activities, including GDP and non-GDP items. Assuming there is little change in the level of non-GDP activities, therefore a decline in bank deposits must feed directly into a decline in GDP.
But the decline in Eurozone bank balance sheets is not so much in deposits, but related to the euro system’s quantitative tightening, simply because the reduction in bank reserves held at the central banks is not in public circulation. At the margin, some deposits may be destroyed by the reduction of bank balance sheets, which probably explains the miniscule drop in the M3 total. That being the case, we should conclude that current concerns about a recession forecast by slowing GDP are for the moment overdone.
It is worth making this point in order to establish where the Eurozone is positioned in the cycle of bank credit. While the monetarists don’t necessary understand the drivers behind their mathematical approach, we can simply assume that until the risks of bank balance sheet leverage are properly addressed, bank credit in connection with GDP activities will stagnate or even contract, taking economic activity into contraction as well.
The condition of the major Eurozone banks
Confirmed by the leverage of the Japanese banks, a consequence of negative interest rates has been excessive balance sheet leverage for the Eurozone’s GSIBs — the global systemically important banks. Undoubtedly, this is due to credit margin compression because of the ECB’s interest rate policies and the attempt by these banks to maintain shareholders’ profits. Many years of declining interest rates and the lack of stimulative effect on CPI inflation will have led to a lazy conviction that the ECB could continue to keep interest rates suppressed at or below zero without inflationary consequences. Therefore, there was no significant danger expected of an increase in interest rates, lulling bank executives into a belief that record levels of bank leverage were justified. Furthermore, bankers act as a cohort, swapping views in bankers’ clubs and other forums in all the major banking centres. And if Bank A is successfully maintaining its profits having taken its balance sheet assets to equity leverage to twenty times, then the pressure is on Banks B, C, D, and E to follow suit.
This competitive groupthinking drives every bank credit cycle to dangerous levels until lending conditions change. Usually, there is evolving evidence which leads bankers to believe that lending risks are increasing, rather than a specific event. And when that happens, the banking cohort always acts in synchrony, trying to contract the asset sides of their balance sheets. That was what happened at the peak of the last lending cycle, when the risks from liar loans backing collateralised loan obligations suddenly dawned on them. This time is somewhat different with the event of sanctions against Russia being a bankers’ wake up call in Europe, because of the impact on energy and food prices and the write-offs they had to make on Russian exposure.
In fact, interest rates measured by bond yields along the maturity curve were already rising before the Russian sanctions were imposed, and consumer prices were beginning to rise as well. But seemingly complacent bankers swallowed the transient inflation story being promoted by all central bankers at that time. Subsequently, they have learned that there were increasing lending risks both for financial and non-financial activities. And while consumer inflation is subsiding, in unison their inhouse economists are now forecasting a deteriorating business outlook.
