Breakingviews

Cyprus is the last of Europe’s baby bailouts

By Neil Unmack

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Hit by a perfect storm of economic slump and man-made disasters, Cyprus has been forced to seek euro zone help. Though implementing reform could be controversial, the 10 billion euro rescue is peanuts for the zone’s bailout funds. Europe will need a different strategy to cope with Spain and Italy.

The Cypriot economy has been hit by the euro zone crisis and rising unemployment. It has also suffered two separate catastrophes; an explosion at the main electricity plant which generated half the island’s electricity, and Greece’s debt restructuring, which left Cypriot banks with severe losses on their holdings of Greek government bonds. Despite being locked out of markets since mid 2011, Cyprus has got by borrowing from Russia.

Cyprus will probably need about 10 billon euros, equivalent to roughly 55 percent of GDP. Deutsche Bank reckons it needs 4.2 billion euros to cope with banks’ losses on Greek bonds and loan write downs, and a further 6.3 billion euros to fund deficits and maturing debt until 2015. In this scenario, debt would peak at about 99 percent of GDP in 2013. But that would be optimistic if Greece left the euro; bank loans to the Greek economy total just shy of 120 percent of Cypriot GDP.

Though the euro zone is getting used to bailing out its members, Cyprus won’t be easy. The country will need to tackle a lingering competitiveness problem, evidenced by persistent current account deficits, forecast at 7.8 percent of GDP this year. The government is implementing a diet of austerity and wage freezes, but euro zone paymasters may be tougher, and will also want a crackdown on tax-collecting inefficiencies and evasion. The risk is that reforms get bogged down by presidential elections next year.

Luckily, the size is small. The euro zone’s bailout funds can easily finance Cyprus from their existing resources, and there is no immediate need for a Greek-style private sector debt haircut. Yet the Cypriot bailout marks the end of an era for the euro zone. It has bailed out four relatively small countries, and is now rescuing Spain’s banks. The next problems are Spain and Italy. With 526 billion euros of debt maturing over the next two years, they are far too big for the Cyprus treatment.

Mario Monti pinned between two comedians

By Hugo Dixon

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Mario Monti is pinned between two comedians. Beppe Grillo, a professional comic and leader of Italy’s so-called second force, wants the country to quit the euro and default on its debts. Silvio Berlusconi is also toying with euroscepticism as he attempts a comeback. This makes it much harder for a technocrat prime minister to manage the crisis.

The phenomenal rise of Grillo’s Cinque Stelle movement has shaken up the political landscape. In two months, its support has shot up from 7 percent to 20 percent, according to SWG, the pollster. Grillo has benefited from disgust with the ruling class, in much the same way as Alexis Tsipras, the radical leftwing politician who almost won Greece’s last election. The Italian comic’s anti-politician message, which initially appealed mainly to people on the left, is now striking chords on the populist right.

Berlusconi’s centre-right PDL, which is supposed to be backing Monti, has been the principal victim of Grillo’s rise. Its support has declined from 25 to 17 percent. The former prime minister has therefore himself started suggesting that either Germany should quit the euro or Italy should bring back the lira.

If Monti had his own party, these shifts in popular mood might not matter too much. But he doesn’t. What’s more, an election must be held by next spring and there are even fears that Berlusconi may force an early one in the autumn.

Monti, who has lost momentum after a strong start as prime minister, may yet find a way of pushing through a second wave of reforms. But confidence in him has collapsed, from 71 percent when he took over from Berlusconi in November to only 33 percent now. Although he is backed by the centre-left PD, the country’s most popular party, he risks becoming a lame duck.

No quick wins for Egypt’s new Islamist president

By Una Galani

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

Egypt’s Islamists will find victory bittersweet. The Muslim Brotherhood’s Mohamed Mursi is the Arab nation’s first freely elected president. But the role comes with limited power and may be short-lived. The long-repressed movement will struggle to deliver on its promise to jumpstart the ailing economy.

 The economic challenge is daunting. GDP contracted by 1.4 percent in the first quarter after seasonal adjustments, according to Capital Economics. Foreign reserves are now worth just three months of imports and the government faces a double-digit fiscal deficit amid rising financing costs.

Private investment is a key pillar of the Brotherhood’s economic plan. Yet the election of a president won’t be enough to convince investors to return. The Brotherhood made its promises at a time it had already won the largest share of parliament which has now been dissolved. That likely sets back the army’s handover of legislative power by up to five months. The polarized country must first agree on a constitution and may then require fresh elections.

Nor can the Brotherhood rely on a big aid deal. The International Monetary Fund has grown comfortable with the Islamist movement. But the IMF requires fiscal commitments which Egypt’s new president doesn’t have the power to make. It isn’t clear how much say Morsi will have over the spending plan that began in June – which the Brotherhood says is full of “extravagant state spending”. 

 The Brotherhood’s hopes of a quick economic turnaround look optimistic. But it could be worse. The value of the Egyptian pound has held for longer than expected. The state could finance itself for another five months with the help of a $1 billion deposit due from Saudi Arabia, a likely revaluation of gold reserves and foreign currency inflows from two state-backed M&A transactions.

The world’s central banks are running out of road

By Peter Thal Larsen

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

In the global economic crisis, central bankers are often portrayed as superheroes. Mario Draghi: the only man who can save the euro zone. Ben Bernanke: “please do more” for the U.S. economy. The Bank for International Settlements is unhappy with the image of omnipotence: its latest annual report laments that central bank money-printing and support for the financial sector are reaching their limits.

There’s no question that central banks have taken extraordinary measures. They have made negative real interest rates seem normal in the world’s advanced economies. They have bought vast quantities of government debt or offered vast sums of cheap, long-term loans to banks. Their balance sheets have swelled: at the end of 2011, the combined assets of the world’s central banks stood at $18 trillion – double their pre-crisis level, and equivalent to 30 percent of global GDP.

This monetary largesse has many bad side effects. It reduces the pressure on governments to reform and for banks to recognise bad loans. It distorts financial markets and encourages new recklessness. It pushes up asset prices in emerging markets and other perceived safe havens. And the longer it goes on, the harder it is to unwind.

The BIS is right to worry. Central banks cannot do everything. It is also right that sovereign debt is high: most advanced economies would need to run an annual budget surplus of more than 2 percent of GDP for a decade to get their debt-to-GDP levels back to pre-crisis levels.

 And yet, there is something unreal about the BIS analysis. If the world’s largest countries simultaneously ran surpluses, or even cut deficits sharply, the almost certain result would be a global slump. Also, the worries about excessive debt do not square easily with historically low government bond yields.

Canada scraps to sidestep U.S.-like housing woes

By Robert Cyran The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Canada is doing its best to avoid the housing woes experienced by its neighbor to the south. A new set of mortgage reforms will make it even harder for Canucks to borrow. Yet ultra-low interest rates keep feeding a residential real estate boom that three previous government initiatives haven’t stopped. Prudent regulation can only limit so much the distortions created by easy money.

A few important policies have helped inoculate Canada. While Americans can generally walk away from a home loan without penalty, Canadians don’t have that luxury. Mortgage interest isn’t tax-deductible in the Great White North. And regulations forced Canadian banks to keep more loans on their books. All this encouraged greater prudence.

Yet there are worrying signs something still isn’t quite right. Canada’s debt-to-income level has rocketed to more than 150 percent, higher than in the United States. Bank of Canada Governor Mark Carney just warned about the proportion of housing investment in the economy. And more than 7 percent of employees work in construction. That’s above the rate reached in the United States at the height of the boom.

What’s more, prices are still rising. Over the past three years, the average house nationally is worth 20 percent more, according to the Canadian Real Estate Association. Prices in Toronto have increased 30 percent. And Vancouver home values shot up so much they inspired a website daring visitors to discern a local crack house from a luxury mansion. There’s no better incentive for financial recklessness than watching neighbors get rich from imprudence.

Stricter limits on government-backed mortgages with a loan-to-value ratio over 80 percent will help. So will making borrowers repay faster, lowering the maximum amount lent against a borrower’s salary and limiting guarantees to homes worth less than $1 million.

Denmark is another costly refuge

By Ian Campbell

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

European and triple-A rated? Tick. Definitely not in the euro zone? Tick. No external financing gap? Tick. With at least a few solvent banks? Yes! Denmark ticks all the boxes. It is a safe haven. Unfortunately, the little country – 5.5 million people – is crowded these days and it is charging investors to park their assets in the harbour.

Denmark is attracting euro refugees. What investors are buying is not a proxy for the euro – which the Danish krone has shadowed at a close to unchanged rate throughout the common currency’s existence – but a proxy for the Deutschmark. Were the euro to break up, Germany would have a strong currency and the krone would be likely to shadow it. The krone could rise then sharply – but only in case of disaster.

Denmark should be able to keep its strong-as-Germany currency promise, because it is like Germany, only better. Danish government debt is a little below 50 percent of GDP – far better than Germany’s 82 percent, and Copenhagen isn’t saddled with euro zone bail out problems. Like Germany, Denmark runs a healthy current account surplus – more than 5 percent of GDP. While the Danish fiscal deficit will rise above 3 percent of GDP next year, that aberration should prove brief.

Unlike Greece, Spain, Portugal or Italy, Denmark doesn’t need foreign financing. That makes foreigners all the keener to supply it. These refugees are becoming a problem for the Danish central bank, the DNB, though not yet on a Swiss scale. The krone has risen against the euro by a miniscule 4 cents, less than half of one percent. To prevent further appreciation the DNB is buying up euros, expanding its forex reserves by 11 percent in the past year, and driving down interest rates to pitiful levels. A sale this week of 2-year notes produced a negative yield of 0.08 percent.

You can’t lose in the Danish harbour. But you have to pay to get in. And you won’t win – unless Germany ships out of the euro.

Regulator grudge match redux: Geithner vs Bair

By Daniel Indiviglio The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Get ready for round two of the “Bair versus Geithner” sparring match. Sheila Bair may no longer run the FDIC, but she has formed an independent group to push forward reforms in the U.S. financial system. The primary pressure point will be the council of regulators led by Treasury Secretary Timothy Geithner. While the two have tangled before, their interests are now aligned.

Bair’s Systemic Risk Council, a sort of Justice League of once-superstar watchdogs, wants to ensure financial reforms introduced as part of the Dodd-Frank Act will actually get implemented. The bipartisan group includes former heads of nearly every major regulator, along with economists, bankers, and retired senators.

Some of its goals are fairly uncontroversial. The body wants the Office of Financial Research to beef up its data collection and analytics system and for global regulators to share data. But others aren’t so simple. For instance, the group is calling for a quick resolution of the complex Volcker Rule, the new bank capital framework and derivatives market reforms.

The Systemic Risk Council holds the Financial Stability Oversight Council, the prudential oversight body consisting of head federal regulators, responsible for delays in making this happen. According to Bair, the council, or FSOC, hasn’t exhibited the leadership needed to get things done. Geithner sits at the head of its table, making him Bair’s implicit target.

Bair, a Republican appointee, and Democrat Geithner have clashed before. During the 2008 crisis, then-New York Fed President Geithner wanted regulators to use whatever means necessary to stabilize the system. To protect the FDIC’s insurance fund, Bair fought against bailouts she considered too lenient. She was also instrumental in helping Wells Fargo take over Wachovia, scuppering a previously agreed deal with Citigroup that Geithner helped engineer.

In the present situation, Bair and Geithner should have common cause: to finalize financial reforms. That doesn’t mean there won’t be friction. As Bair surely appreciates, in the face of bureaucratic inertia and intense external lobbying these things are easier said than done. But at least until Geithner steps down at the end of the year, the match-up offers a more constructive replay of some of the more tense moments of the crisis.

Taking the leverage out of economic growth

By Edward Hadas The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

It is a truism that economies have become more leveraged because the issuance of debt has increased faster than nominal GDP. As the debt mountain expanded, it became more dangerous. The challenge now is to reduce leverage without choking growth. It’s a challenge that is still largely ignored by monetary policy.

Economists from Deutsche Bank have analysed the problem. They start with the “credit impulse”: the change in the rate of growth of new private credit. For the last two decades, accelerating credit has been closely correlated with the change in GDP – both in the United States and the euro zone. GDP growth tended to speed up shortly after the rate of credit growth increased, and slowed down after credit growth started to decrease.

This correlation implies there is an equilibrium rate of credit growth – the rate that corresponds to the long-term pace of nominal GDP growth. Though the pace of credit growth can vary from year to year, over time private debt and nominal GDP have to expand at the same rate for overall leverage to stay constant. That’s not what happened in the past two decades. Since 1990, Deutsche found a significant gap between credit and GDP growth in the United States and the euro zone.

In both, the neutral rate of credit growth – the rate associated with the economy’s long-term growth rate – was 7 percent. Those long-term nominal GDP growth rates were lower: 4.8 percent in the United States and 4 percent in the euro zone. In a single year, the difference of 2-3 percentage points doesn’t have much effect. Over a generation, though, it leads to a massive increase in the ratio of private debt to GDP.

This leads to financial crisis. In the United States, debts mounted disproportionately in the property and financial sectors, leading to booms followed by busts. In the euro zone, credit expansion allowed several countries to live far beyond their means.

More generally, the expansion of debt makes the financial system more fragile. Increased leverage amounts to imposing a larger financial structure on the same economic foundation. As the ratio of loans to underlying values increases, those values become more dependent on the continued availability of credit. More loans are written without any clear asset as collateral. The chains of borrowing almost inevitably become longer and more entwined. Slight setbacks in growth or minor changes in mood can cause substantial losses. And since debt has to be frequently rolled over, there are many opportunities for self-fulfilling panic.

Bankers need to follow the money into China

By Wei Gu

The author is a Reuters Breakingviews columnist. The opinions expressed are her own.

China’s mainland is the new battle ground for global banks. Goldman’s new vice chairman Mark Schwartz is set to be based in Beijing, and others will follow. Mainland exchanges account for the majority of this year’s initial public offerings in Asia. The challenge for global banks will be finding their niche, and adequate talent.

As the mainland gains, Hong Kong suffers. Global banks are making selective cuts in Hong Kong, especially in equities. Morgan Stanley’s mainland Chinese joint venture already has around 150 staff despite being just a year old, according to a person close to the matter. UBS, the only foreign bank with a Chinese brokerage license, has transferred a managing director from Hong Kong to Shanghai to build an 80-90 person research team.  

Fees are dictating the shift. China’s A-share investment banking fees almost quadrupled since 2007 to $2.2 billion, now making up half of overall China-related banking revenue, up from less than a fifth in 2007, according to Thomson Reuters. This trend is even more evident this year. Three mainland exchanges have taken up 66 percent of Asian IPO proceeds, while in Hong Kong, IPO proceeds have fallen 90 percent year on year.

As the markets loosen up, China will get more attractive. Global banks have already been told they can take up to 49 percent stakes in their joint ventures, and can apply for secondary market licenses after two years of operations, versus five years before. Once Shanghai finally opens its new market for foreign companies, global banks will have a new edge against local securities firms.

There are challenges ahead. Deals are smaller in China, and reputational costs can be high. Local bankers may have good connections on the ground but lack technical skills. Transferring talent from abroad is costly, and high taxes and heavy pollution make people less willing to move to China. Still, if the money is to be made in Beijing and Shanghai from now on, banks and bankers have no choice but to adapt.

Corporate earnings hopes are still too high

By Robert Cole

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Equity analysts are sharpening their red pencils. As euro zone worries clog the wheels of global commerce, forecasts for corporate earnings are falling. Yet global investors may still be expecting too much from companies, at least in the near term.

Estimates for the S&P 500 index of U.S. companies have been steadily hacked back in recent months. Last July, analysts expected earnings in the current quarter to grow 18 percent, according to Thomson Reuters’ “This Week in Earnings” report. Now they think the constituents of the S&P 500 will improve their combined earnings by only 6.5 percent in the three months to the end of June. Take out financials – the absence of last year’s Bank of America lawsuit settlement will flatter growth in 2012 – and the prognosis is for earnings to shrink year-on-year. Take out Apple, whose size and strength boosted aggregate earnings growth in the first quarter from 5.7 to 8.1 percent and the picture gets bleaker still.

Over in Europe the bad news is worse. Earnings of euro zone companies shrank by 6 percent across the whole of 2011, Thomson Reuters data shows. And while the latest estimates suggest there could be growth in 2012, it is sobering to recall that, this time last year the 2011 consensus was that euro zone corporate earnings would rise 9 percent.

Monetary stimuli of the sort signalled by the U.S. Federal Reserve on June 20 may help to prop up the economy, and markets. Low equity valuations, especially in Europe, also offer some protection. The forward price-earnings multiple for U.S. shares is 12, compared to a 25-year average of 15. European stocks trade on a multiple of just 8 times expected earnings for this year. Some disappointment is already priced in.

Nevertheless, profit warnings this week from Procter & Gamble and Danone suggests forecasts may still be too high. And history suggests that when corporate earnings go into reverse, the shift is rarely gradual. Since 1971, the combined earnings of S&P 500 companies have expanded by an average of about 8 percent a year. In periods that failed to meet that norm, however, earnings typically shrank by 6 percent on average. This could be one of those years.