Constantin Gurdgiev on the EM Funding, DM Growth, and FI Market Effects of European Bank Deleveraging

Eurozone banks face significant challenges as they attempt to delever and pare risk weighted assets going forward. We spoke with Dr. Constantin Gurdgiev, Professor of Finance at Trinity College, Dublin, and Head of Global Research at St. Columbanus AG, about what this will look like from the perspective of the markets for securitized loan products as well as the developed-market and emerging-market economies interlinked with the eurozone banking system. On asset sales by European banks to facilitate deleveraging and the associated balance-sheet risk:

As far as the mark-to-market versus not marked-to-market, it's hard to ascertain right now. Some of the banks have been rushing to mark to market--a little bit closer to realistic valuations. They will have to take losses, beyond any doubt. Once they start dumping those in the market, you can estimate somewhere between 5 to 15 percent of bank assets will probably go into the market in the next six to nine months as the banks across Europe are either trying to raise capital to cover the losses or deleveraging under the so-called reform proposals across the different European countries. You are going to have a glut of assets flooded into the market, which will trigger additional write-downs across the banks themselves. The big problem is in the structures of European economies, which are linked to the banks. So, in my view, the big knock-on effects are that you are going to have lack of liquidity within the system, which is exacerbating the asset sales themselves. You are going to have that plus this systemic, what I would call, "deleveraging drive," which means that the supply will vastly exceed any sort of demand for bank assets. As a result of that, bank asset valuations will contract and bank lending will effectively stop in the real economy. That will have a knock-on effect on corporates across the eurozone, especially since European corporates are much more dependent on bank financing than say, for example, U.S. or U.K. corporates, where equity plays a much greater component in financing. You are going to have a long-term structural weakness in European growth. It's going to be beyond the eurozone, because if you look at the links, for example, that the likes of the central and eastern European economies have to the core European banking systems, you will have a very significant growth contraction in the potential rate of growth going forward there as well. Your capex will drop, your consumer demand will drop, your domestic investment will drop. At the same time, you are going to see effective interest rates--strangely enough--rising, because the banks are seeking more funding. At the same time, bank margins are shrinking. This is really the effect of capital buffers being rebuilt in the long term. That will create a twin squeeze effect on growth as well. You can see that down the road what is coming is really new capital calls on the exchequers across the eurozone. Again, that will depend on the particular country, obviously. I would expect Germany to face quite a bit of that, and the French will probably as well face significant calls for additional capital from them. That will lead to the ECB balance sheet exploding, both on the sovereign side and on the emergency liquidity assistance side. National central banks are going to get flooded with additional repos of lowest quality, as usual. The whole problem is going to be exacerbated as a result.

On how this "deleveraging drive" in Europe will affect emerging market financing and growth:

Emerging markets are slightly different in that context because for real, non-financial capex, emerging markets generate their own cash flow. That, of course, is underpinned by positive current account surpluses in those economies. While the slowdown in Europe in terms of demand is going to have an impact, the deleveraging of the European banks is not going to have a direct impact on emerging markets because unlike the U.S. in particular and the investment banks, the traditional European banks do not hold much of the exposure to the emerging markets--outside of eastern and central Europe and parts of the Commonwealth of Independent States. What I would suspect there, in terms of emerging markets, is that what they will see is that most of the capital generated internally will have to compete, in terms of rates of return, with high yields on capital in the eurozone. That will, to some extent, help the eurozone--slightly, it's not sufficient--but it will also reduce the supply of cheaper capital within the emerging markets. Of course, you will have a global interest rate shock--not the policy rates that central banks set, but the actual retail rates paid in the economy itself.

On the specific effects of US dollar-denominated asset deleveraging in Europe:

We've already seen in the September-October period several spikes in the sales of assets by European banks in the United States. As a result of that, we've seen knock-on effects in certain asset classes. MBS, as far as I know, haven't really been impacted. We've seen on the EURUSD where that had an impact, so they were sizable disposals, and in particular, by the French banks. Where the real issue is here is the balance between the quantity of capital and quality of assets held. If the banks were to deleverage in an orderly and structured fashion, then the likes of MBS will go first into the market, in which case, there will be a very strong knock-on effect on the U.S. It wouldn't be immediate, but it would be fairly pronounced. At the same time, I don't think they will do that, because they haven't done that yet. What the banks have done in Europe so far in terms of deleveraging is that they've dumped the most valuable assets, strangely enough. That is counterproductive, but they've done it because it raises the most capital for them. As a result of that, you might end up with a situation where European banks will emerge from at least the first stage, a rapid stage of structural deleveraging, with balance sheets, on average, stuffed with lower-quality [assets] than before.

On the prospect of monetization of these assets:

It's very clear to me that, for example, both the Federal Reserve and the European authorities are willing to do absolutely anything to preserve the status quo of the European banking system. The Federal Reserve is doing it for the sake of the stability of the dollar market itself, which is understandable. The European authorities have shown, very clearly, that they are unwilling to even contemplate a systemic purging of insolvency across the European banking system. As a result of that, this is precisely why I am saying that the balance sheets of the national central banks and the ECB will swell with assets. Of course, we know that, because they've already done it. If you look at the quality of assets which have been used for repo operations at the ECB, the quality is so poor that a large part of those assets would not be salable in the market. When you go down the line and you look at the actual underlying quality of assets which are repo'ed into the national central banks--the likes of, for example, Portuguese or Italian or Irish central banks--the quality there is even worse. In the Irish central bank, the collateral in them is a junior type of paper guaranteed by the Exchequer of Ireland. In other words, it is an insolvent entity guaranteeing junior-quality paper. That paper qualifies for repos at the national central bank. That is to increase.

On future problems caused by central bank balance sheet expansions:

Unwinding that without creating inflation will be impossible because any sort of sterilization of this this type, of the injections of liquidity into the banking system will instantaneously trigger a great depression, rather than a great recession, across the eurozone. We are looking at interest rates in the double digits--for a very long period of time. The European economy cannot exist without cheap credit. We know that because it never existed without cheap credit. There is no real exit out of this precisely because the eurosystem itself has clearly opted for the unsustainable solution of preserving the existing status quo of the banking system in Europe at any cost. That cost, sooner or later, will have to translate into the cost of the real economy.

On what the eurocrats will likely try next:

They will try to pursue the EFSF leveraging and they will bring forward the ESM as well. Whether they will be successful in achieving both of those objectives, I would have significant doubts. Whether, for example, the EFSF leveraging--even if it is successful--will resolve the problem, I am doubtful as well. The problem is that all of the solutions that have been tabled so far--even the most far reaching ones, such as eurobond issuance--all run into one single problem: you cannot resolve the problem of insolvency by getting another credit card. Nothing about the EFSF makes sense other than the realization that the EFSF was set up in a panic mode by headless chickens running across the coop. The structure of the EFSF, from the point of view of preservations of AAA ratings, and the negative leveraging which it has started with--which is now being reversed into the positive leverage they hope to achieve--none of that makes any sense. The ESM, the permanent of the EFSF, which we would presume assumes liabilities of the EFSF--otherwise it is very difficult to see how they can effectively re-borrow the amounts of funds which are allocated already under the EFSF into the ESM from day one--even that mechanism itself makes no sense. You have to look at the macroeconomic indicators here. The eurozone, as a whole, is very much in trouble itself. For all the claims about the positive dynamics in Germany and France and so forth, the eurozone debt-to-GDP ratio right now is in excess of 87 percent, and it is rising. Given the liabilities of the common down the line, especially after the bank recapitalizations and things like that, you are looking at the debt number exploding--rising well above 100 percent--in the next 3-5 years. So, as a result of that, the eurozone on the whole is already on the brink of insolvency itself. You cannot resolve, therefore, the problem by assuming they will bring more debt into the eurozone. The eurozone needs a very robust restructuring of both its financial systems and its sovereign systems. By restructuring, I mean good, old-fashioned defaults, "haircuts," on some of their assets.

Constantin Gurdgiev also writes the blog True Economics.