Irrashaimasse - Welcome to Europe's Money Circle

·         The last week brought some good news from the Eurozone, when it was announced that M3 had risen 3.2% yoy in March. It also brought the most comprehensively disturbing report about the Eurozone for some time – the quarterly banking survey of credit conditions and loan demand. It is wrong to accept the M3 positive surprise at face value, and it is correct to worry about the contents of the banking survey.

·         What the two together describe is a near-complete divorce of the Eurozone banking system its private economy. The largesse offered by the ECB to the banks has made no difference. Rather, money being pumped into the banking system is travelling a closed circuit between central banks, governments and banks, and back again. It pumps up balance sheets and it primps out M3, but it does nothing else. It will do nothing to ameliorate the Eurozone's recession this year. In the longer term, the lesson is bleak, and delivered entirely in Japanese.

These relationships are important, but not overly complicated, and this piece traces them. We start with the actions of the ECB and explore what impact these have made. From there we can move directly to the banks' balance sheet and trace the answering relationships between the banks and governments, and how this makes an impact on those M3 numbers. Finally, we highlight the results of the quarterly banking survey, which underline how the frantic money-spinning between European central banks, commercial banks and governments bypasses a private sector which, in turn, has effectively given up on the banking system.

The First Circle - ECB's Largesse

We shall start with the impact of the ECB's various liquidity rescue packages. These include both the Eu 1tr Long Term Refinancing Operation (LTRO) and the more contingent Emergency Liquidity Assistance (currently running at around Eu121 bn, apparently, according to a footnote to last week's ECB balance sheet statement.

The LTRO had two legs: first, in December, the ECB auctioned cheap three-year loans, and accepted applications of Eu 489.2bn from the Eurozone's banks. A second tranche of auctions was held at the end of February, which resulted in a further Eu529.5bn.

But the bald total of Eu 1tr in ECB cheap money presents an inaccurate picture of the increase in ECB financing partly because the three-year funding partly replaced, rather than supplemented, other short-term funding sources, and partly because a great deal of the net money borrowed was re-deposited immediately back with the ECB. These effects were overwhelming. Between the beginning of December and roughly now, the ECB's lending to banks rose by Eu 487 bn, but voluntary deposit made back into the ECB by banks (not counting those needed to cover reserve requirements) rose at the same time by Eu464 bn. So in the end, ECB's net lending to the Eurozone's banks rose by around only Eu23bn.

So although the ECB's balance sheet expanded by around Eu 530 bn since the beginning of December 2012, the vast majority of this expansion was, one might say, self-cancelling.

Second Circle: Banks and Governments and M3

Now we come to this week's good news, that Eurozone M3 growth accelerated to 3.2% yoy in March, from 2.8% in February. This means that M3 is growing faster now than at any time since June 2009. More, for the third month in a row, we have seen sequential growth of more than a full standard deviation above historic seasonal patterns. How can this be anything but encouraging? 

The thing to remember is that monetary aggregates are measurements of financial institutions' liabilities – the stock of money they purportedly contain. It is when we look at the changes in the assets backing those liabilities that the problem emerges. For the only assets that are growing are banks' credits to government, made either in the form of loans, or in the form of government bonds held. That credit grew by 7.3% yoy in March, up from 5.6% in February. Meanwhile, growth rate of credit to the private sector came in at only 0.5%.

If we look directly at Eurozone's bank balance sheets, we find that during 1Q12, banks raised their holdings of government bonds by Eu120bn, whilst they raised their private loans by just Eu 2bn.

Meanwhile, in an echo of what we found with the central banks' attempt to expand credit to the banking sector, the increased lending to government is also largely self-cancelling. For example, we have mentioned that banks' holdings of government bonds rose Eu120bn during the first quarter. What did the government do with the money? Why, most of it they gave back to the banks: government deposits during the same period rose by Eu 83bn. Deposits of the private sector during the same period rose by just Eu24bn.

By the end of March, government deposits represented only 2.9% of total bank deposits: but during 1Q, the rise in government deposits accounted for 77.5% of the rise in total deposits. In truth, the banking system's interaction with the private sector has stalled, and the recovery in monetary aggregates is almost solely a circular set of book entries between the central bank, governments and financial institutions.

Consequences – For the Banks

Does this matter? It matters because it means the banks have raised their exposure to Eurozone sovereign bonds: they are now equivalent to 144% of total bank capital, up from 140.2% at end-December. Every sovereign credit downgrade must therefore be expected to erode bank capital.

But more, as banks commit more capital to government debt, this crowds out private lending – the direct opposite of the dynamic which drove the Eurozone economy during the first seven years of its life. Between the beginning of the Euro and the outbreak of the financial crisis, credit exposure to governments had fallen from 240% of bank capital to a low of around 143% - and it is that withdrawal from financing government which helped finance lending to the private sector. Since 2007/08, the tendency has been for that ratio to rise – except in times of exceptional crisis – and subsequently for credit conditions to the private sector to tighten. As long as the banks continue to think the safest way to make money is to lend to governments, there's no reason for that to change. 

Consequences 2 – Private Sector Abandoned  

Which brings us to the ECB's quarterly bank lending survey, which studies changes in the way banks interact with the private sector. It makes ugly, depressing, reading.

The survey asks banks two sets of questions: first, are they tightening, or easing, the conditions under which they make loans; second, are they experiencing rising, or falling, demand for loans. They study conditions for corporate loans, of residential mortgage loans, and of consumer credit.

Let us look first at credit conditions.

It is easy to misread this graph: the uptick in credit conditions during 1Q doesn't mean conditions eased, just that they tightened less dramatically than in 4Q11. Conditions for corporate credit, for residential mortgages and for consumer credit were all tighter in 1Q than they were in 4Q11. For corporations, credit conditions have got progressively tighter each quarter for the last 20 quarters (ie, since 2Q07). For residential mortgages, the run of continuously intensifying tightening has run 19 quarters, and for consumer credit, 18 quarters. The ECB's funding largesse may have slowed the pace, but it has been unable to stop the ratcheting up of tightening credit conditions.

But, if the non-stop tightening of credit conditions is bad, the collapse of loan demand is worse, and is once again intensifying quite dramatically. The measurement here is simply the percentage of banks which report rising loan demand, minus the proportion that report dwindling demand.

The collapse in loan demand from enterprises during 1Q12 was steeper (in marginal terms) than any experienced at any point of the financial crisis. The net reading of minus 30% is the most extreme since 1Q09, and reverses a period during 2010-11 where loan demand was actually increasing. To repeat: this is the most extreme onset of financial caution that the Eurozone has seen at any stage of the financial crisis. And since we know that private sector deposits are now barely growing, it is unlikely the collapse in loan demand simply signals that companies are happy with their liquidity position.

The collapse in demand for credit isn't confined to companies. The household sector's demand for residential mortgages has fallen to its lowest reading (minus 43%) since 4Q08. Households' demand for consumer credit is declining faster now than at any time since 1Q09.

Conclusion

The conclusion is inescapable: with ever increasing intensity, Eurozone banks don't want to lend to the private sector, and with ever increasing intensify, the Eurozone private sector doesn't want to borrow from the banks. This is getting more, not less, pronounced. Its immediate result will be intensifying and lasting recession.

And after that? I've seen it before. You can call 'irrashaimasse!' or you can simply say 'Sayonara'.

The important differences between the Eurozone now and the Japanese economy post 1990 is that after Japan's banks died to the private sector, the economy could run purely on the cashflow generated via its structural current account surplus, whilst the prevailing interest rate structure made a decade or two of structural fiscal deterioration possible. Neither are true of the Eurozone, so we can be sure that the cost of closing Europe's banking system won't be as relatively painless as just two lost decades.