Evercore Pan Asset

There was a flurry of activity in Brussels and Frankfurt as the old year drew to a close. The EU member states have agreed a Treaty amendment to take effect in 2013. This will give clear legal support to a new Euro bailout fund organised by the EU and Euro member states. The Bank of England offered a swap to the European Central Bank to improve its sterling liquidity. The EU considered what more it needed to do to achieve financial stability, and promised more stressful stress tests for EU banks in 2011.
 
Meanwhile the markets have been giving their verdict on the Irish bail out. Billed once again as the bail out to end the troubles, both for Ireland and the Euro zone, the market reaction has been far from encouraging. Yesterday Irish ten year bond yields were around 9% compared to 2.9% for Germany in the same currency. Irish debt was downgraded to baa1 in a dramatic downgrade that showed the world is not yet persuaded that Ireland’s finances are mended. 
 
The problem remains that Ireland has suffered a sharp decline in economic activity. With more spending cuts to come, high interest rates on the new borrowing, and a currency which Ireland can neither print nor devalue, some people worry that Ireland will not achieve the growth it needs to pay the interest and in due course to start paying off the debts. Irish banks remain in need of substantial state and European Central Bank support. If the Irish economy does not recover vigorously and soon, there could be more property and commercial losses to come on Irish loans. Irish nominal Gross National Product is down a massive 26% from peak at the end of 2007. Real GDP is down by 13%. These are big losses, which hit the tax base and increase the social security payments, making it that much more difficult for the Irish state to rein in its deficit. 
 
The Euro crisis will get worse if the EU and the ECB between them cannot help Ireland to re-establish strong banks and a growing economy. An IMF programme would include devaluation, to help a country become more competitive. This is largely ruled out all the time Ireland is in the single currency. Ireland has to keep squeezing wages and unit costs to compete better, at the same time as cutting public spending to try to bring down the deficit. These moves are all deflationary. They mean less spending power and consumption at home. 
 
In 2011 the danger is the Euro system will put too much pressure on too many weaker countries and economies. Greece is not fixed. She had to renegotiate her May loan this November, to lengthen it to give her more time to try to turn her declining economy round. Like Ireland, Greece needs economic growth and more jobs. Greek real GDP is almost 10% below its peak in 2008. The Spanish problem also looms for 2011. Five groups of Spanish Cajas or savings banks were said to be weak when the EU did its last banking stress tests – tests which the Irish banks all passed. The European Central Bank is keen to wind down its special measures to support Spanish and other EU area banks. Can they do so in a controlled manner which does not panic the markets?
 
The European banking regulators tell us all the larger EU banks are trading and are solvent. On that basis the European Central Bank should make as much liquidity available to them as they need. However, others in the market, and maybe even the ECB itself, are not so sure that these banks have adequate solvency for all conditions. They think these banks do not just need more liquidity but they need more capital, more profits, and more profitable business. These rows sometimes spill out into the public debate and undermine confidence in   the system.
 
The truth is the EU has not worked out how to finance countries that have falling output and rising budget deficits. They have not thought through a recovery policy that can generate the growth they need. They have not decided how to make all banks super solvent so there are no more fears about them. Until they do these three things convincingly Euroland will be subject to further market shocks. We advise investors to stay away from the area in the meanwhile.