It is too obvious to bear much repetition, but the agreements reached by Eurozone governments this week – even if they put on both detail and actual financial muscle (here's looking at you Mr Jin Liqun) – are not exactly a rescue package. And that's because, once a heavily indebted country is set to swim with an unfeasibly heavy exchange rate strapped to its ankle, the only place it's going, even with encouragement from the sidelines, is down. No-one any more is even pretending that the 'rescue' package will allow Greece to grow in the long term. Rather, the ambitions of the package have been reduced simply to averting imminent financial breakdown within the Eurozone. Or, to be more specific, averting the imminent seizure of the Eurozone interbank markets.
The comparison usually made is between the situation in the Eurozone now, and the situation in US banking markets immediately prior to the collapse of Lehman Brothers in 2008. One of the key moments there was when it became clear that the interbank market was failing – specifically, that the price banks were charging to lend to each other was actually higher than banks were being obliged to pay directly from the money markets. As the chart below shows, in the US this collapse of interbank trust (or 'credit') arrived like a thunderbolt out of the blue in late September 2008, peaked at just under 200bps within three weeks, and – being intolerable – had been treated by extraordinary Fed action within a further two weeks. It was short, and extraordinarily painful.
Now look at what's happening in the Eurozone currently. Euro-libor discounts to money market rates had been eroding steadily throughout 2010, and finally broke through to the distress-premium at the beginning of August.
However, since then the premium has neither spiked (a la Lehman), nor has it gone away. Rather, it continues to grind away, simply asserting as a fact that Eurozone banks now trust each other less than the market trusts them. Of course, this has the makings of an imminent crisis but, absolutely crucially, has not yet become one. What we have looks like chronic financial angina, rather than the full infarction.
Why? I can identify two reasons. The first is the one I pointed out weeks ago – namely that I think Eurozone banks have taken quite extraordinary steps to ensure that the US money markets cannot put them under irresistable pressure offshore. As I pointed out then, this has entailed those US-located branches keeping more cash than they have deposits, and also reversing their traditional funding patterns to become net fund-suppliers to US interbank markets.
The second relates to what is not happening in Credit Default Swap markets. Back in 2008, it was the realization that CDS market losses were potentially large enough to sink each and every financial institution, and that there was no way of actually knowing if or to what extent back-to-back offsetting CDS liabilities might or might not actually net off, that did the damage. When banks realized too late that if CDSs aren't fully fungible, then when the chips are down the 'offsetting' CDS just don't 'net out' to zero, then they stopped lending to each other.
This time, perhaps the greatest coup being pulled off by European negotiators has been to engineer (seemingly – time will tell) a situation where financial institutions are prepared to take a 50% write-down on holdings of Greek sovereign debt without triggering the default clauses in the CDS market.
One has to ask, if the 50% haircut on sovereign debt doesn't amount to a sovereign default, then what does?
Most specifically, one has to assume that as far as Eurozone sovereign debt is concerned (and bank debt too, to the extent that the banks are or will be nationalized), there is no point in buying credit default swaps on anything other than a pure non-deliverable forward basis – ie, it's strictly for the spread-bettors.
Well, it does if the market for Eurozone sovereign debt prices in the fact that its investors are now denied access to credit insurance, and have only a restricted ability to short. Surely as the terms deteriorate, so the the interest rate demanded on Eurozone sovereign paper must be expected to rise. Unless there are exceptions. It will, for example, be interesting to see what sort of terms China's sovereign wealth-fund will be offered – will CIC demand the ability to hedge fully and in whatever way it chooses?
What conclusion can one draw? In the short term, Eurozone banks have done a good job in insulating themselves financial in those financial markets its regulators cannot quash. Elsewhere, the bits of the market bringing bad news have been sidelined or shut down. Both give Eurozone banks a better short-term survivability than their US counterparts in 2008. This buys time. The danger – no, the likelihood – is that this time will have been bought very expensively, and will be wasted even more expensively. Why? Because, as so many countries discovered in the 1930s, if you hobble your economy with a vastly over-valued currency, your growth prospects are blighted until you change it.