Mood music

Key points:

  • Rays of light: the global dataflow is getting less uniformly bleak. A lot still hinges of the trade negotiations between the US and China, but the “mood music” is more soothing.
  • European banking union: the (strictly conditional) German offer on deposit insurance is welcome, but we focus here on the shortcomings of a piecemeal approach. Without fiscal integration in parallel progress will be difficult.
  • Keeping an eye on Italy: the new coalition is navigating rough waters. The “spread compression phase” may have come to an end.
  • Beyond Italy: the results of the Spanish elections add to the general “political statis” situation in Europe.


Rays of light on the global dataflow

Sometimes central banks are lucky. We expressed last week our concerns over whether the Federal Reserve had provided enough of a pre-emptive accommodation to afford a pause, but we have had some positive surprises last week. “Contagion” from manufacturing to services is the biggest threat to the cycle right now, and the rebound to 54.7 in October from 52.6 of the US non-manufacturing ISM index came as relief after the steep decline in September. It is always daunting to make scenarios dependent on one piece of data – and the Non-mfg ISM has been quite volatile lately – but it is clear the markets seized on this as evidence it is not too late to “stop the downturn in its tracks”, especially after the better-than-expected payroll data released a week earlier.

Market optimism has been further fuelled by the statements from negotiators on both sides on the possibility that the conclusion of the “phase one deal” between the US and China would come with a gradual roll-back of at least some of the tariff hikes already implemented. In our view, investors for now will tend to discount any additional disappointing data from the manufacturing sector globally – for instance the further significant drop in industrial production in Germany in September, also released last week – as the product of “pre-deal announcement” pessimism.  Of course, if the deal ultimately fails to materialise, or proves less broad in scope than expected, the backlash in terms of confidence will be severe. President Trump stated on Friday he had not yet made up his mind on tariff roll-back. This may be pure negotiation tactics to snatch last minute concessions from Beijing, but this will keep investors on their toes, especially since after the cancellation of the APEC summit in Chile the date of Trump/Xi meeting remains elusive.  


European banking union and the order of priority

German Finance Minister Olaf Scholz offered in a column in the Financial Times to boost the Banking Union project, which had stalled since delivering an operational framework for single supervision and single resolution, with at long last a European Deposit Insurance Scheme (EDIS). Given how unpopular this concept is in Germany it is undoubtedly an important step, especially in the current context of mediocre progress on all aspects of European integration. However, when looking hard at the 8 pages long “non paper” issued the same day by the German Federal Ministry of Finance (BMF), we are impressed by the thickness of the red lines set up by Berlin. More fundamentally, we are sceptical about the chances of success of a “piecemeal approach”. In our view, other member states are likely to comply with those red lines only if there is progress on a fiscal stabilisation capacity at the Euro area level and/or the emergence of a joint “safe asset”.

Our main point of focus is the BMF’s insistence as a pre-condition for EDIS on introducing a non-zero risk weight on banks’ exposure to sovereigns when calculating their regulatory capital ratios. This is a long-held view in Berlin, and one Jens Weidmann has often supported publicly. In principle this makes sense: it is difficult to convince people to contribute to safeguarding the savings of citizens of another country where a fiscally un-responsible government could be putting local banks at risk through their excessive exposure to the sovereign. In practice though, the transition costs could be seen as unbearable, or unfair by a number of member states.

The BMF non-paper offers some concessions. In particular, “concentration” (i.e. the exposure to one single sovereign) would be exempt from a capital charge up to 33% of the Tier 1 capital of the bank. Beyond that, the capital charge would move in line with the degree of credit risk, based on ratings. The non-paper does not quantify the capital charge, but we can provide a framework to work out how national banking systems would be hit by the new system, using the data the European Central Bank (ECB) publishes on 111 “significant institutions” it supervises (Exhibit 1).


Exhibit 1 – Even with concessions, non-zero risk weighting of sovereign exposure could be costly in some member states


We calculate for each country the exposure to government debt which exceeds the 33% threshold proposed by BMF. In the last column of the right we compare this “new risk perimeter” to the current volume of risk-weighted assets used to calculate the capital ratios. The potential shock would be significantly smaller for German banks than for their counterparts in Italy, Spain and France.  Note that the ECB source we use only provides aggregate data for overall exposure to “general government” overall. This covers central government bonds but also loans to local authorities. The BMF only mentions “bonds” in its non-paper so we may be overstating the impact of such a reform. Also note that in the French case, given the high rating of local sovereign debt, the capital cost would be much more manageable than for Italy. Still, even taking those caveats into account, the non-German banks – and the non-German sovereign funding costs – would be net losers. The rejection of Scholz’ proposal by the Italian finance minister on November 7th is thus not very surprising.

True, as another concession, the BMF paper makes it plain that the “charge” itself would be “calibrated in such a way that it would not involve excessively large additional capital requirements for Eurozone banks …challenges resulting from the transition could be mitigated by having an appropriate phase-in period (5 to 7 years)”. Still, even if the transition costs can be kept in check, some adverse side-effects would emerge in our opinion. The quantum of banks’ exposure to the sovereign is probably excessive in some member states, but the changes in relative exposure may be perfectly reasonable from a macroeconomic point of view.

In adverse cyclical conditions, banks face a decline in the demand for credit from private borrowers and a deterioration in their credit worthiness. Banks then need to shift their asset allocation towards a less-risky borrower which is experiencing a rise in its borrowing requirement (the government). Conversely, when the recovery starts, banks can resume allocating their balance sheet towards the private sector. This has been the pattern in Italy and Spain over the last 15 years when we look at loans to the non-financial private sector versus holdings of public debt. Of course, national idiosyncrasies affect the patterns (e.g. the steep de-leveraging of the private sector when the Spanish housing bubble burst) but fundamentally they continue to hold.

Now, what would happen with a concentration charge? Banks could still move away from lending to the private sector in times of cyclical deterioration – something which by the way will be exacerbated by another “red line” set in the BMF’s document: the need to keep the net non-performing loans ratio below 2.5%. But instead of flocking to their own sovereign, banks would be incentivised to shift towards the debt of the best-rated member states (all the more so since rating agencies are likely to downgrade sovereigns in adverse cyclical conditions). This means that the absolute level of yields would fall where they are already low, while the spread weighing on the more fragile member states would widen.

True, what we are experiencing at the moment is the opposite of the peripheral crisis: the cyclical downturn is more acute in Germany than in the rest of the euro area, and German banks would also need to deal with their own concentration issues. But as we suggested in Exhibit 1, the quantum of asset-reallocation they would face is much smaller than in the other countries. In case of an asymmetric shock affecting the periphery only, the concentration charges combined with the non-performing loans (NPL) limits would add to the usual “flight to quality”, reduce the financial capacity of the peripheral governments to accommodate the shock fiscally and lower yields in Germany where the economy is usually insensitive to the interest rate.

There would be two ways to address these potential shortcomings: one would be a form of “dynamic regulation”, taking into account the cycle. The other would be more fiscal mutualisation.

With “dynamic regulation”, the threshold beyond which the concentration charge would kick in would be lifted in adverse macroeconomic circumstances (and the same could apply to the NPL limits by the way). Governance would be an issue though. Who would assess the cycle and decide? It could be the Single Supervisory Mechanism, a.k.a. the ECB, but this would further concentrate economic powers in one institution. There would be signalling effects to take into account as well (the decision to “lift” would be quite binary and would generate tactical market positioning).

With fiscal mutualisation – or to be more precise the creation of an effective cyclical stabilisation fund at the euro area level – macro shocks would have a lower probability to significantly impair the fiscal sustainability of individual member states. Rating agencies explicitly take into account the level of European institutional support when grading the sovereigns. By “nipping in the bud” a recession and protect governments’ credit worthiness, the probability of steep asset re-allocation by banks would diminish if a proper cyclical stabilisation capacity was created. This would make the introduction of sovereign risk weights more acceptable to the more fragile states. If such cyclical stabilisation vehicle was able to fund itself by issuing its own debt, this would add to the mix the possibility for banks to invest in this joint, low-risk asset in times of turmoil, instead of flocking to the core countries.

How to make progress on fiscal mutualisation and how to complete banking union are two key topics for the future of European integration. In our impression, Berlin is offering some movement on the latter to reduce pressure on the former (and “concentration” is only one red line, since Scholz would also make EDIS conditional on swift changes on cross-border bank capital treatment and harmonisation in corporate tax). But in our view, the two topics can hardly be addressed separately. We still need to see a holistic strategy for the future of the monetary union.

Keeping an eye on Italy

The collapse in the Italian sovereign spread has been one of the good news of 2019. The generalised search for yield explains a lot of it of course, but the end of the Lega-5 Star populist coalition has been a key ingredient. Still, we have noted earlier in Macrocast that the new coalition was taking a risk in allowing Lega to improve its popularity once in opposition. The recent data point in that direction. The Centre-left Democratic Party (PD), in alliance with 5-star, lost another stronghold to the Lega-dominated centre right in the regional election in Umbria by a wide margin (20 points). True, there were idiosyncratic issues with the region’s former PD administration and Lega’s leader Salvini invested a lot of time and energy in this particular vote, but the leaders of PD and 5 Star had to acknowledge that their agreement is not “electorally additive”, fuelling concerns over another episode of political instability in Rome. Another important test will come on January 26th with regional elections in Emilia-Romagna, another historical stronghold of PD. In addition, the government is facing two potential referendum battles next year, one on the stark reduction in the number of parliamentarians, the other on the electoral system. PD and 5Star are not necessarily fully aligned on these themes, with Lega stoking the fire and Renzi’s new group potentially adding to the political confusion.

True, if new national elections had to be organised now, the new coalition would very likely lose. This may be enough for the two parties to be convinced that it may still be worth continuing with the current arrangement as long as possible. But we suspect the market, which since Salvini’s failure to trigger elections and the shift in coalitions had given Rome the benefit of the doubt, is from now on going to become much more attentive to political developments South of the Alps. Markets usually focus on the Eurosceptic noises coming from the centre right. These had played a major role in the spread widening last year. Salvini is probably more aware of this now. Crucially, on October 14th, he publicly stated that “the Euro is irreversible”. The populist streak in the centre-right may focus less on European issues and more on immigration. If this holds, a rising probability of Lega coming back to power would not necessarily trigger the same quantum of spread widening as in 2018, but we suspect the “spread compression phase” has come to its end.

Even if the new coalition survives, we think investors may start asking: “to do what?”. The main benefit from the new coalition, in terms of Italy’s financial standing in the markets, is the removal of the risk of an open confrontation with Brussels. Even if there will need to be some “nip and tuck” to make the budget bill for 2020 completely compliant with the European rules, this benefit is holding. Still, beyond this short term issue, focus could return to the fundamental macro story of Italy, and while cyclical conditions have not soured lately as much as it could be feared, the country is still facing daunting structural challenges, and there is not enough policy convergence on deep reforms between PD and 5 Star to deliver much on this.


Beyond Italy: Europe in political stasis

Based on 97% of the votes collected by the Interior Ministry at the time of writing this note, no party or formal coalition has won an absolute majority in the Spanish national parliament. The current left-wing coalition between centre-left PSOE and radical left PODEMOS (with its various regional variants) has seemingly won 155 seats in the lower house. That is 21 seats below the majority threshold. A wide right-wing block joining Partido Popular, Ciudadanos and VOX seems to be further away from the threshold with 150 seats. It is traditionally possible for left-wing parties to secure the support of regional parties, while it would be next to impossible for the centre-right block to achieve this, given their strong centralist tradition. So it may still be possible for the current socialist Prime Minister Pedro Sanchez to stay in power, but with a quite fragile government, and reaching out to regional parties in the context of the lingering Catalan crisis is not going to be straightforward.

This brings us to a general feature of European policy-making in Europe at the moment: near-paralysis. Italy’s new coalition is fragile. The coalition in Germany is facing its own challenges while Angela Merkel’s leadership is fading. Paris continues to generate ideas for another “European leap” but irrespective of how the French proposals are received on substance, it is very difficult to move in a situation in which national governments in a lot of member states are already facing significant “existential” issues on their domestic turf.

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