European ‘Project’ Not Irreversible, New Paper Says

[LeveragedBuyout]

Interesting prescriptions, and very European in character (more government spending, more regulation, and more government investment in the private sector). It's only been tried about 10 times before, but perhaps the 11th time will do the trick.

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Getting Investment in Europe Right by Jean Pisani-Ferry - Project Syndicate


BUSINESS & FINANCE

JEAN PISANI-FERRY
Jean Pisani-Ferry is a professor at the Hertie School of Governance in Berlin, and currently serves as the French government's Commissioner-General for Policy Planning. He is a former director of Bruegel, the Brussels-based economic think tank.

OCT 31, 2014
Getting Investment in Europe Right
PARIS – The European Commission’s new president, Jean-Claude Juncker, has put public investment back on the agenda with his idea of a three-year €300 billion ($378 million) capital spending plan. The European Union’s leaders are expected to discuss his proposal in December. Everyone seems to agree that more investment would help to strengthen a worryingly feeble European economy. But, behind the superficial consensus, many questions remain unanswered.

For starters, this is not the first time that Europe has considered such an initiative. In 1993, the Commission, under Jacques Delors, proposed a capital spending plan in its White Paper on growth, competitiveness and employment. The plan was broadly endorsed, but no action was taken. Likewise, in 2000, as part of its Lisbon Strategy, the EU sought to increase national spending on research and development to 3% of GDP. It failed to reach this target. More recently, in June 2012, EU leaders adopted a Compact for Growth and Jobs that was supposed to mobilize €120 billion. The check is still in the mail.

It is indeed easy to pretend to act without taking effective action. One way is to ask the European Investment Bank (EIB), the EU’s development bank, to lend more. Such calls face two limitations: the EIB itself is careful not to jeopardize its financial rating by taking on too much risk, and its loans easily substitute for private financing. More lending therefore can be pointless if it results in the EIB crowding out private financing of the best available projects. A bridge financed by the EIB may be more affordable than one financed by capital markets, but it remains the same bridge and has the same economic impact. The size of the EIB’s balance sheet is not a good measure of its effectiveness.

Instead, three investment levers should be used. The first lever is budgetary: Governments that enjoy fiscal space should spend on economically sound projects. Public investment is a complement to private investment; if designed and targeted well, it can trigger more private investment, rather than crowding it out.

For example, adequate transport and broadband infrastructure favors the burgeoning of business initiatives. At a time when markets are willing to lend to solvent governments at historically low rates, there should be little room for hesitation.

Obviously, cheap financing does not justify public investment in projects with dubious social returns, or what development practitioners call “white elephants”: headline-grabbing projects of disputable value but supported by special interests. Investments should be assessed on the basis of their overall economic impact, with proper procedures put in place to prevent public money from being wasted.

The second lever for investment is regulatory in nature. Many large-scale investments that only pay off over the long term – for example, in energy, digital infrastructure, and transport – are concentrated in state-regulated sectors, giving governments the power to influence business decisions.

Predictability regarding the future course of regulation would unlock projects held back by uncertainty. A credible outlook for the price of carbon, for example, would prompt new private-sector investment in cleaner technologies. Similarly, an agreed European framework for projects that connect countries would remove obstacles to cross-border investment.

These conditions are a long way from being met, which means that profitable investments are not being made. Changing that would not cost a single euro; it requires only political resolve.

The third lever is financial. Investment demand has slackened not because interest rates are too high, but because there is not enough risk appetite within the banking system. Financing in continental Europe is traditionally bank-based, unlike in the US, where capital markets reign supreme. But banks are being told by regulators to reduce their leverage and to post higher capital when they embark on risky lending, and their creditors are being told that they should not expect to be bailed out if banks get into trouble.

This is intentional. Governments and citizens in Europe have paid – and are still paying – an astronomically high price for the reckless lending and investment of the 2000s. Understandably, they do not want to repeat the experience.

The consequence, however, is that high-risk, high-return projects are more difficult to finance than they should be. If Europe wants to revive its economy and escape stagnation, it needs entrepreneurs to take more risk to innovate. But its financial system is undergoing a transition from a bank-based to a market-based system that involves risk aversion.

This is where the public side – both national governments and the EU – should step in and share some of the risk with private players. They should temporarily behave more like investors who scrutinize projects, contribute funding, and earn returns. Using the EIB and national development banks to this end would help overcome the current impasse.

Would these three types of initiatives add up to €300 billion? No one knows at this stage. But this route would be the surest way to reach the goal.

Getting Investment in Europe Right by Jean Pisani-Ferry - Project Syndicate


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[LeveragedBuyout]

My commentary: The bottom line is that Italy and Greece's banks are ailing, but because the "stress test" criteria were somewhat lax, it's possible that many more European banks are in worse shape than officially thought. Until realistic scenarios are planned for (specifically prolonged deflation, which is a strong possibility) with the necessary capital raised, Europe's economic recovery will continue to be tepid. N.B. Capital must be raised because it is thought that a large percentage of outstanding loans are non-performing (i.e. in default and/or have no prospect of being repaid), and thus banks are cutting back on lending to preserve their capital base.

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News In Charts: The Stress Test Results Are In - And It's Trebles All Round! | Alpha Now | Thomson Reuters

NEWS IN CHARTS: THE STRESS TEST RESULTS ARE IN – AND IT’S TREBLES ALL ROUND!
October 31st, 2014 by Fathom Consulting

Results of the ECB’s Comprehensive Assessment of the 130 largest euro area lenders were published last weekend. The regulator detected a total capital shortfall of €25 billion spread across 25 banks. Almost four fifths of the shortfall was accounted for by banks in Italy and Greece. Even the least-pleasant scenario left the banks with an aggregate CET 1 capital ratio of 8.3%. So on the face of it, all is well. Trebles all round! And yet, although this exercise was undoubtedly more ‘stressful’ than previous somewhat half-hearted attempts, regulators nevertheless failed to consider the consequences for bank balance sheets of a prolonged period of deflation across the single currency bloc, to which financial markets attach a probability in excess of 40%. Nor indeed was any attempt made to model the impact of an Italian default, which would follow a prolonged period of deflation in much the same way as night follows day. Our own calculations suggest that equity-market pricing values bank assets at more than a trillion less than their book value, an order of magnitude different from the ECB’s estimates.

“The scenario of deflation is not there because indeed we do not consider that deflation is going to happen”. Those were the words of ECB Vice-President Constancio speaking at a press conference held in Frankfurt to announce the results of the Comprehensive Assessment (CA). His words, of course, ring more than a little hollow, not least because euro area inflation had already dropped as low as 0.7% when the scenarios were being hatched last December – it is now 0.4%. Moreover, call us old-fashioned, but we think that stress tests should be based not on the most likely outcomes, but on a set of unpleasant, yet feasible scenarios. Finally, someone should alert Mr Constancio to the fact that his native Portugal is already in outright deflation.



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First the facts

As our table shows, the capital shortfall was estimated at €25 billion, spread across 25 banks. Twelve of these had already covered this shortfall in the course of 2014 by raising €15 billion in capital – the rest will have to prepare capital plans within two weeks and cover the shortfall within nine months. As the amounts involved barely total €10 billion we do not anticipate serious problems on this front. An Asset Quality Review (AQR) formed part of the CA. The AQR downgraded bank assets by a total of €48 billion. Only €11 billion of the €48 billion is counted within the total capital shortfall of €25 billion. The remaining €37 billion of downgrades were not sufficient to push the bank holding the impaired asset below the CET 1 capital ratio limit of 5.5%.



In addition, using a standard definition of Non-Performing Loans (NPLs), Frankfurt estimates that the total of NPLs is €136 billion higher than previously thought – arriving at a figure of €879 billion in total. Taking out interbank and sovereign lending and focusing only on loans to “Other euro area residents” (item 1.1.3. in the ECB’s aggregated balance sheet of euro area MFIs), we estimate that the NPL ratio of lenders in the common currency area is 8% or thereabouts. Unless and until this mounting NPL problem is addressed, we see little prospect of a pick-up in euro area credit growth. Credit continues to fall, year on year, across the single currency area as a whole, with banks in the periphery leading the way. Even in Germany, credit growth stands at just 0.7%.



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All is well then?

In an effort to make this assessment more credible than previous iterations the ECB applied a little more stress than it had done in the past. In the worst-case scenario, Common Equity Tier 1 (CET 1) capital ratios drop to 8.3% from 12.3% currently. While this is a larger fall than in previous stress tests – allowing the supervisor to pat itself on the back for conducting a “rigorous exercise” – it is nonetheless well above the 5.5% threshold that would trigger widespread and non-trivial recapitalization requirements. Perhaps the most serious shortcoming of the latest set of tests is that, while the growth outcomes considered could be considered arduous, no attention was paid to the prospect of a prolonged period of deflation. To be precise, in the ECB’s baseline scenario inflation increases gradually to 1.5% in 2016, from 1.0% in 2014. In our own forecast, published last week, we expect inflation to average 0.2% through 2015. But if China lands hard, there will be outright deflation across the euro area. Interestingly, in the Fed’s upcoming stress test, their ‘severely adverse scenario’ has the single currency bloc falling into outright deflation, with headline inflation dropping below -1% in the second half of 2015.

The ECB appears satisfied with the results of the CA, but we are less easily pleased. Concessions were made to Greek lenders, who were permitted to use more favorable balance sheet data from this year, rather than 2013 data used by other countries. This, together with the fact that the ECB ‘discovered’ no substantial recapitalization requirements, speaks of a political decision to bury the underlying problems. The alternative, of course, is that someone would have to pay the cost of recapitalizing the region’s ailing lenders. And under the ‘national backstops’ mantra this task would fall first to the sovereign – Spain or Italy for instance. Except these are precisely the countries who can least afford to contribute.

With a capital shortfall of €3.3 billion (€9.7 billion before 2014 capital actions) Italian banks performed the worst in the CA, signalling more bad news for Italy. As we set out in last week’s News in Charts – ‘The Long March to Deflation?’ – Italian debt dynamics are rather unpleasant. Even if both growth and the primary balance were to return to their long-run averages, Italian debt would be unsustainable at an inflation rate of 0.6% – the rate currently implied by five-year break-evens. Hence, the Italian sovereign is in no position to bail-out its banks. The kicker is that 10% of Italian banking assets comprise Italian sovereign bonds – this is the vicious circle of impaired sovereigns and ailing banks, the so-called ‘Doom Loop’, in action.

Market-pricing implies a much bigger shortfall

We also ran some Merton model analysis on the euro area’s banking system and found that, while market-implied asset values have risen considerably from their lows at the height of the crisis, they are still some way short of book values. We estimate the gap at over €1 trillion, and while this is not an exact science, we can be confident that the market-implied shortfall is an order of magnitude higher than the ECB’s valuation adjustment of €48 billion, or the remaining capital shortfall of €10 billion.
The Centre for Risk Management also publishes a measure of capital shortfall. They estimate it to be roughly €800 billion compared to the paltry €10 billion suggested by the ECB. They find that the French banking system is the least well capitalized, but the single worst offender is Deutsche Bank.



Essentially, the ECB is playing extend and pretend on a continental scale. So long as the regulator continues to find that, by and large, the banks that it regulates have sufficient capital, then the sponsoring sovereign will not be forced to part with yet more money that it does not have. As it is, Spain’s banks are, apparently, a mere €30 million away from perfect health.



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We will watch, with interest, how the markets react to these results in the coming weeks. So far they have been less than ecstatic at the news. The Eurofirst 300 banking index has shed almost 4% since the results were announced, while the all-sector index has actually risen. As our chart shows, between mid-2007 and mid-2012, euro area bank equities lost some 60% of their value, relative to the all-sector index. They have remained depressed ever since.

 

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The Eerie Silence Before the EU Reform Storm - Carnegie Europe

The Eerie Silence Before the EU Reform Storm
Posted by: JAN TECHAUTUESDAY, NOVEMBER 4, 2014

Perhaps never in the history of the European Union has there been a greater mismatch between the need for reform and the political capital available to enact that reform. So what will bring the EU member states to the point where they embrace meaningful change in that union of theirs?

This is the question that has been lingering in the air in Brussels as the new EU leaders have begun to take office. Everybody knows that it can’t go on like this, few trust that anything major will change, and many have an inkling that something big is about to occur. The atmosphere resembles a political drôle de guerre—that unnerving phase of silence and tension that everybody knows must end soon so the real battle can finally be fought.

The current combination of challenges facing the EU is extreme, even by the union’s crisis-ridden standards. That calls for an equally momentous reform effort.

First, the EU needs to address the possibility of the departure from its ranks of one of its leading members: theUnited Kingdom. The UK is a country with a positive long-term demographic outlook, firm liberal economic leanings, a strategic view on the world, and a rock-solid transatlantic orientation. There aren’t too many member states like that, and the EU certainly doesn’t want to lose them.


Second, the EU faces a Europe-wide sclerosis that has created structural unemployment, enormous debt, low growth rates, and lackluster innovation across the continent. Europeans have lived beyond their means and at future generations’ expense to such an extent that harder times with longer work and diminished privilege are unavoidable.

Europe’s lack of preparedness to deal with this sclerosis can be seen in the prolonged economic failure of France, another of the EU’s indispensable members and the second pillar, after Germany, of the single currency. The utter ossification of France’s political elite and the rusty mechanics of the country’s centralized republic have led to systemic paralysis and a huge populist backlash against modernity, openness, and economic and political liberalism.

To be sure, reforming France is ultimately a French task. But so much depends on it for the EU that some hard thinking needs to be done—at least in Berlin, London, and Brussels.

Third, the populist backlash visible in France is a harbinger of what might follow in the EU as a whole if the bloc does not decisively reform its governance structures soon. This will mean creating some sort of democratic participation in the EU that makes Europeans true citizens of the EU, not just token ones.

The European Parliament, in its current form, cannot address the EU’s democratic deficit. Nor can subsidiarity or stronger national parliaments improve the union’s democratic credentials. If the current level of EU integration is to be maintained—or even increased, as necessity seems to dictate—the union will have to establish real Europe-wide participation in EU decisionmaking in the not-so-distant future.

This is highly unlikely. And yet, if it does not happen, the EU will start to come apart.

Democratic participation and its logical consequence, political union, are more likely within the eurozone than across the EU. Just as the currency’s founders envisioned, the euro will require a political union of some sort that creates legitimate governance of the EU’s already deeply developed economic integration.

What the founders did not envision is that political union for the eurozone will also force the fragmentation of the EU. Not all members want political union. But those inside the eurozone clearly need it. Between these two forces, the EU’s future will have to be negotiated.

Fourth, the EU will have to forge a real common foreign policy, at least in those fields where the union’s survival could be at stake. This foreign policy should include integrated and hard-nosed approaches to the Eastern and the Southern neighborhoods, military cooperation, energy security, immigration, Europe’s attitude toward Asia, and cybersecurity.

The EU is miles away from any of this. The union is, for the most part, a bystander in classical foreign policy with occasional success stories and lots of drift. It still relies on an order that it is ever less capable of underwriting with its own assets. That is not a survival posture.

So far, so ugly.

But what will bring about constructive, well-designed, daring change? The cynic’s view is that only more pain will do the trick. Europe has had it too good so far, so there is no real sense of urgency.

Modern political science’s way of expressing this is what Joseph M. Parent, a professor at the University of Miami, claims in his 2011 book Uniting States: Voluntary Union in World Politics. His point is that throughout history, political union among nations has only ever sprung from a shared mortal threat. Short of that, no union.

Others are less pessimistic. Olli Rehn and Jean Arthuis, both Liberal members of the European Parliament, and a former European commissioner and former French finance minister respectively, recently stated in an op-ed for the Financial Timesthat “all the stars are aligned for big changes in Europe.”

Rehn and Arthuis claim that 2017 is the magic year to watch. The UK will likely hold a referendum on its EU membership in that year, Germany and France will hold major elections, the EU’s multiannual budget will undergo its regular midterm review, and the EU’s fiscal compact is expected to become EU law.

The year 2017 could well be an important one, but it remains to be seen whether the combination of these factors can free up enough energy to deal with so many fundamentals at the same time.

No matter whether the political events calendar can instigate reform or whether existential threats from within or outside will spur the EU into action, reforms need to be enormous in scale and workable at once. The margin of error is small. Even under the best of circumstances, the slow nature of political decisionmaking and the enormous complexity of the issues at stake make reform unlikely. And at any point in the process, a breakup is a possibility.

The EU’s dilemma is that clinging to the status quo will destroy it, but that resolutely moving on could equally tear it apart. Europe might still have its best days ahead of it. But before that time comes, Europe has something else ahead: the toughest calls it has ever made.