Tags: eurozone | ECB | stress | bank

Eurozone Crisis Is Not Over Yet, and a Triple-Dip Can't Be Ruled Out

By    |   Tuesday, 28 October 2014 09:34 AM

European Central Bank (ECB) President Mario Draghi warned on Saturday that further steps toward sharing sovereignty in economic governance are absolutely necessary. And this was before we got the results of the ECB stress tests Sunday on what the ECB considers as the most systemically important banks of the eurozone. I really can't see how Draghi's goal of shared economic governance will ever be achieved, not least of all because of the continuous (and growing) opposition of Germany.

Anyway, the ECB stress tests are what they are and should help the ECB on its way for creating a banking union, although the tests have a series of flaws that could have been avoided and that will not be helpful.

It's really interesting to see the ECB negating the not-so-imaginary threat of a deflation scenario at a moment when Eurostat reported two weeks ago that the annual inflation rate for the eurozone stood at 0.3 percent, which equates to almost zero inflation once the tax effects are stripped out, and when among others, Italy (-0.1 percent) and Spain (-0.3 percent) remain trapped in deflation territory on a year-over-year basis.

To me it's mindboggling to hear the ECB Vice President Vitor Constancio say: "The scenario of deflation is not there, because indeed we don't consider that deflation is going to happen."

Looking a little bit deeper in the stress tests report, it becomes clear they haven't taken into account what caused the "Lehman" bankruptcy, which was at that time the fourth-largest investment bank after Goldman Sachs, Morgan Stanley and Merrill Lynch, and clearly have underestimated the risks of a serious shock.

In that context, a new study titled "Robustness, Validity and Significance of the ECB's Asset Quality Review and Stress Test Exercise," which was done at the request of the EU Economic and Monetary Affairs Committee, shows that capital shortfalls, when estimated using regulatory capital ratios instead of book and/or market capital ratios, of the sampled 40 public banks could total 454 billion euros, or $575 billion, in case of a really serious shock. The ECB stress tests showed that the banks had a shortfall of 855 million euros, or $1.08 billion, while the banks' assets showed an overvaluation of 48 billion euros, or $61 billion.

Yes, that independent study is certainly not a "white-washing" exercise and contrasts sharply with the results of the ECB stress tests.

Of course, this is strictly my personal opinion based on what I've learned from this important "study."

Besides all that, I still have that unanswered question: "Who is going to pay if shortfalls are identified since there are diverging interests between the ECB and the respective 18 national regulators?" Not easy to answer, for sure. The only thing that's for sure is, if it were to occur, it's going to be a messy crisis once again.

To me, it's still way too early to take on risks in the eurozone, its financial sector included, but that doesn't mean there aren't interesting opportunities out there. The problem is, you have to find them.

Long-term investors should certainly not overlook the fact the euro remains on its path to a substantial lower exchange rate that could go to parity. If I'm right, this would be a drop of approximately 20 percent during the next couple of years.

As always, everybody has to make investment decisions on a strictly personal basis, but as a long-term investor I'd certainly not overlook that enlightening and "neutral" study.

Of course, there are many more flaws that came to the open, but I can't go into detail here, because that would take way too long.

Anyway, apparently parts of the majority still seem to have a different opinion and the goldilocks-inspired "hypes" could come back with a vengeance. Already we learned Spain is studying reducing collateral for covered bonds, which are debt securities backed by cash flows from mortgages or public sector loans.

To me, the eurozone crisis as a whole is not over yet, no, not by a long shot . . . and a triple-dip can't be ruled out yet.

Please keep in mind the "vicious cycle" between the now 18 states in the eurozone and its banks has remained well-anchored and the eurozone banking union is still no further than a project under discussion.

Nevertheless, the latest ECB stress tests are undoubtedly helpful for the eurozone banking union project itself. If that's enough to restore solid confidence and if that will help to revive demand for loans from the private sector, the banks being under less stress remains to be seen.

In context of all the above and according to ECB's Constancio, the subject of the ECB's reported plans to purchase corporate bonds is not scheduled for discussion during next week's ECB Governing Council meeting. The earliest it could be on the table is January in case the credit sector remains too weak.

For all investors any extra form of expanding the ECB's balance sheet is important, as it can be expected the moment the ECB starts purchasing corporate bonds we should see another thrust down of the euro/dollar exchange rate (paying less in dollar terms per euro).

In fact that's exactly what happened after June 13 when the ECB introduced a negative deposit rate of 0.2 percent. Since that date we've witnessed a non-negligible rise in the value of the dollar. On June 13 the EUR/USD was 1.3540 and it now trades around 1.27, which represents a move of approximately 6.2 percent.

Similarly, the dollar index, which is a weighted geometric mean of the dollar's value compared with a basket of six major currencies, has moved up from 80.61 on June 13 to 85.63 today, which represents a strengthening of approximately 6.22 percent in roughly 4 ½ months.

In my opinion, the course of the value of the dollar will be dependent for the greatest part on the monetary expansion measures the ECB will have to perform in the coming months, taking into account that corporate bond buying will certainly not be enough to spur growth quickly enough.

The dollar's value will be, for the time being at least, completely independent on what the Federal Open Market Committee decides.

It will also be interesting to see if a stronger dollar would go hand in hand with weaker oil prices, as in fact has been the case most of the time, but not always.

One thing is for sure for the moment, if you are invested in U.S. dollar-denominated instruments, stay where you are, but make sure you can exit in full under all circumstances.

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European Central Bank (ECB) President Mario Draghi warned that further steps toward sharing sovereignty in economic governance are absolutely necessary. And this was before we got the results of the ECB stress tests Sunday.
eurozone, ECB, stress, bank
Tuesday, 28 October 2014 09:34 AM
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