A View from the Trenches, February 8th, 2010: "On the Euro crisis: It's an institutional crisis, not a short-term liquidity crisis"
Please, click here to read this article in pdf format: february-8-2010
During the weekend, we did a fair bit of reading and, among other
things, watched an interview Mr. Martin Redrado (now ex-President of
the Banco Central de la República Argentina) gave. It was an unusually
interesting interview to watch (the interview was in Spanish and can be
replayed at: http://www.tn.com.ar/2010/02/04/politica/02133330.html . We will refer to his comments made from minute 10:30 to 11:42).
As you may know, Mr. Redrado gained public attention after he refused
to hand over $6.6Bn in reserves of the Banco Central to the Argentina’s
Treasury, to service upcoming debt maturities. Mr. Redrado had to
eventually resign. In the interview, Mr. Redrado was asked why he
thought the Treasury should not use the so called “excess reserves” of
the Central Bank, if the amount of reserves is higher than the monetary
base in pesos (which the reserves back)? Mr. Redrado answered that the question denoted a misunderstanding
and gave an historical example: In 1989, at the time Argentina had
hyperinflation, the amount of reserves was actually higher than the
amount of “currency in circulation”. Redrado continued to point that
the relevant metric a Central Bank should follow is not “Demand for
currency”, but the potential demand for currency. He explained that under the institutional uncertainty
Argentines face, they may not renew term deposits at maturity (a
component of M2). As these term deposits mature, they become demand
deposits, which people then convert into USD. Therefore, the Banco
Central has to maintain an optimal level of reserves that will guarantee enough supply, to a potential
demand of USD . Term deposits must not be ignored. Therefore, according
to Mr. Redrado, Argentina has no such a thing as “excess reserves”.
(Here, the concept of currency is tricky. Argentines demand USD as a
reserve currency, while they demand pesos as a transaction currency).
Why do I take you precious time to tell you this? Why should you care about this story, if you live in the developed world?
Last Friday, Mr. Jeffrey Rosenberg, Bank of America’s Credit
Strategist wrote an interpretation on the current crisis that the
so-called Euro zone peripherals face (i.e. Greece, Italy, Portugal and
Spain; “Default (even a sovereign one) is a liquidity event”
in “US Fixed Income Situation”, Fixed Income Strategy, February 5th,
2010, Bank of America). According to Mr. Rosenberg, there is no
currency crisis. As these peripherals have their debt denominated in
Euros,”… this crisis is a long term “solvency” crisis precipitating a short term liquidity crisis…”.
Therefore, this is not a typical sovereign currency crisis (not your
father’s crisis), with investors fleeing the countries financial
markets, and all we need is “liquidity support”.
What does Mr. Rosenberg mean by liquidity? He shows us two tables.
In Table 2, we see “Fundamentals behind solvency concern”. Which ones
are these? Fiscal Deficit as % of GDP, GDP, Sovereign debt (in $ and in
% of GDP) and the required adjustment, as a % of GDP. In Table 3, there
is a display of liquidity needs of the Eurozone. The metrics are (for
each member country, in Euro) 2010 bond maturities, Rolling short term
debt, Fiscal deficits and total financing needed. From this point of
view, the natural conclusion is to obtain the scale of the liquidity
support required.
After having heard Mr. Redrado, I could not help smiling at Mr. Rosenberg’s naiveness. Every currency crisis, absolutely every one of them,
is the consequence of the assessment made by its holders, that their
currency no longer can serve both to transact and to act as an asset to
save. The currency can no longer be used to save. Why? The
reason is always institutional. It doesn’t matter what the trade or
fiscal deficits are (the USD is the best example) or what a
government’s financing need is. At the heart of a currency crisis you
have a crisis of confidence in the government. The currency holders ask
themselves: “Will we be “taxed” for holding pesos, or Euros?” The
extreme case of Argentina is a good example. Note that if the Central
Bank’s reserves belong to a government’s Treasury, changing pesos for
another currency constitutes an act of fiscal rebellion!
In conclusion, in my view, the Eurozone peripherals are not facing a liquidity crisis. The
issue is far more serious. The whole European Union is facing an
institutional crisis. Will the Eurozone behave as a Confederation or as
a Union? Under our perspective, the cost for the Eurozone of not
standing up to the circumstance and showing a firm resolution, will be
far, far more expensive than the product of the existing government
financing needs times a higher cost of borrowing, as Mr. Rosenberg
wants us to believe. The European Central Bank must not believe for a
second that what is at stake is a “short term liquidity problem of
peripherals”. Paraphrasing Mr. Redrado’s wise comments, the European
Central Bank must understand that in these peripherals there is also a
potential demand for a reserve currency that will be triggered
violently without notice, if the Eurozone acts as a Confederation,
rather than a Union. In this case, liquidity support lines will be
useless and will only delay a horrible end. What does the Eurozone
need? A unified bond market.
Martin Sibileau
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