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Europe and global credit crisis

Page history last edited by Brian D Butler 11 years, 10 months ago

 

other related pages from GloboTrends:

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Table of Contents:


 

 

Why do Interest rates matter?

 

Think about the Economic Crisis in Europe.  For countries, the interest rates matter.  For their citizens, interest rates really matter.  Imagine...

  • "As lenders have fled from weaker credits, the interest rate on German Bunds has fallen to 1.3 per cent, against 5.8 per cent in Italy and 6.2 per cent in Spain. With flat nominal gross domestic products, countries with high interest rates are at risk of falling into a debt trap. "  Martin Wolf

 

 

What is "Interest"?

 

Definition: An interest rate is the cost of borrowing money.  Read more here: interest

 

 

 

Crisis overview 

 

 

The eurozone, once seen as a crowning achievement in the decades-long path of European integration, is abuffeted by a sovereign debt crisis of nations whose membership in the currency union has been poorly policed, explains this CFR Backgrounder.

 

 

 

 

Country-by-Country analysis:

See our GloboTrends analysis on:

 

 

 

 

 

 

 

 

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OLD material (kept here for reference only):

 

Crisis Update 2011:

 

"Europe is in the grip of tough austerity measures - some of the deepest public sector cuts for a generation. Shockwaves are still being felt from the 2008 financial meltdown, which paralysed bank lending and left much of Europe reeling from huge budget deficits and public debt.  In the troubled 17-nation eurozone Greece and the Irish Republic received huge bail-outs last year from the EU and International Monetary Fund (IMF). Portugal is next in line for such a rescue.  Investors' anxiety about the debts of these eurozone "periphery" countries sent the interest rates (yields) on their sovereign bonds soaring, making it ever harder for them to borrow in international markets.  The 27 EU member states aim to cut their budget deficits to a maximum of 3% of GDP by the financial year 2014-15, so what belt-tightening measures are the countries taking?"

 

 

Read more from BBC here: http://www.bbc.co.uk/news/10162176

 

 

Fiscal crisis 2010

 

Funding needs: "“funding needs” we essentially mean the amount of cash the country needs to borrow or rollover to keep the lights on, keep paying government salaries and keep the government functioning."[1]

 

 

Funds available:

 

  1. The European Financial Stability Facility [EFSF] is the 440 billion euro bailout fund set up this summer by euro-zone governments to try to deal with the more indebted members of the monetary union[2]
  2. IMF money
  3. Total available (as of 2010) -  approx  925 billion euros

 

 

Potential solutions:

 

  1. Create "Common Eurozone bond" -  see article from BBC here
    1. Who is for?  - Italy & Luxembourg
      1. why for? - reduce borrowing costs 
    2. Who is against? - Germany
      1. Why against? -

 

 

 


 

 

 

 

 

 

Fiscal Crisis 2010:

 

 

 

Role of London:

 

Think of the various less-than-transparent actors that have set up shop in London

– Many sovereign wealth funds.

– A lot of the SIVs set up by US (and European) banks were legally domiciled in the UK

– Some credit hedge funds

- And most importantly, a host of European banks with large dollar books (think of them as badly regulated credit hedge funds) ran a large part of the dollar exposure through London.

There was a reason, after all, why residents in the UK were the largest purchaser of US corporate debt over the past few years. Corporate debt – in the US balance of payments data – includes asset-backed securities. Foreign purchases of such debt soared – especially from 2004 to 2007 – before falling off a cliff during the crisis.

 

see  financial innovations

 

 

how the crisis spread from US to Europe

 

see article:  http://blogs.cfr.org/setser/2009/03/08/the-shadow-financial-system-%E2%80%93-as-illustrated-in-three-new-papers-that-cut-through-london%E2%80%99s-fog/#

 

Two papers (one on US money market funds’ role funding European banks and one on European banks dollar funding needs) in the BIS quarterly shed some light on the role European financial institutions played in the rise – and the subsequent fall – of US credit markets.

 

The first paper – by Baba, McCauley and Ramaswamy – explains how US money market funds were a crucial channel for transmitting the financial stress caused by Lehman’s default to Europe’s banks (and then back to US credit markets).

 

It turns out that Lehman (and no doubt other investment banks) and European banks both borrowed heavily from the US money markets. In effect, they shared a common creditor – “prime” money market funds – and when Lehman’s default led the reserve primary fund to break the buck and massive withdrawals from “prime” money market funds – European banks lost access to dollar financing. Baba, McCauley and Ramaswamy write: “the run on US dollar money market funds after the Lehman failure stressed global interbank markets because the funds bulked so large as suppliers of US dollars to non-US banks.”

 

This isn’t really news. There is a reason why the Fed lent $600 billion to European central banks so those central banks – the Fed was making up for collapse of dollar funding from US money market funds. (see graph 6 on p.77)

 

Baba, McCauley and Ramaswamy highlight the huge growth in the dollar assets of European banks over the last eight years. Those assets increased from $2 trillion to around $8 trillion (with Swiss banks accounting for about ½ the total). That growth “outran their retail dollar deposits,” making Europe’s banks reliant on wholesale dollar funding in much the same way that the growth in the assets of the US broker dealers made them reliant on wholesale funding. US money market funds that weren’t limited to Treasury and Agency paper happily met this need: “competition to offer investors higher yields, however, led them to buy the paper of non-US headquartered firms to harvest the Yankee premium.”

 

The BIS estimates that US money market funds were supplying $1 trillion of credit to non-US banks in mid-2008 (dollar denominated European money market funds supplied another $180b ….). That is far more dollar financing than supplied by the offshore dollar deposits of the world’s central banks: “by contrast, central banks … provided only $500 billion to European banks at the peak of their holdings in the third quarter of 2007.”

 

Still, those looking for a direct (rather than indirect) link between central bank reserve growth and boom in lending to US households can find a link here. A fraction of central bank dollar reserves were held in deposit in European banks – and another fraction was invested in onshore and offshore dollar-denominated money market funds. European banks used those sources of dollar “funding’ to buy securities backed by loans to US households. The growth in their balance sheets undoubtedly explains the huge increase in cross border flows (outflows from US money market funds financed the inflows associated with European banks purchases of US securities) during the boom years – and large corporate debt purchases through the UK.

 

The second BIS paper — by Patrick McGuire and Goetz von Peter on the “US dollar shortage in global banking” — uses the BIS banking data (actually, I would say that they tortured the banking data, as the data didn’t yield its secrets without a tremendous amount of effort) to estimate European banks need for dollar funding. It is superb.

 

 

The results are interesting, to say the least. They confirm that the losses that money market funds that held Lehman paper were a key channel of contagion, as European banks depended on US money market funds to meet their need for dollar funding.

 

Among other things, McGuire and von Peter find:

  • – “European banks experienced the most pronounced growth in foreign claims relative to underlying measures of economic activity.”
  • – “After 2000, some banking systems took on increasingly large net on-balance sheet positions in foreign currencies, particularly in US dollars. While the associated currency exposures were presumably hedged off balance sheet, the buildup of large net US dollar positions exposed these banks to funding risk , or the risk that their funding positions could not be rolled over.”
  • – “A lower bound estimate of banks’ funding gap … shows that the major European banks funding needs were substantial ($1.1 to $1.3 trillion by mid-2007).”
  • – UK banks, for example, borrowed in pounds sterling [some $800b] in order to finance their corresponding long positions in US dollar, euros and other foreign currencies. By mid-2007 their long US dollar positions surpassed $300b, on an estimated $2 trillion in gross US dollar claims. Similarly, Germany and Swiss banks net dollar books approached $300b by mid-2007, while that of Dutch banks surpassed $150b …. ” Setser note: this created large positions that needed to be hedged, and meant that if UK banks couldn’t raise a lot of sterling funding to swap into dollars, they would need to go out into the market and borrow dollars directly …
  • – The term structure of the fx swaps Eurpoean banks used to transform their pound and euro funding into dollars “are even short-eterm on average” than dollars borrowed on the interbank market.
  • – “these estimates suggest that European banks’ US dollar investments in non-banks [read holdings of dollar securities and corporate loans] were subject to considerable funding risk …. The major European banks US dollar funding gap reached $1.1-1.3 trillion by mid-2007. Until the onset of the crisis European banks had met this need by tapping the interbank market ($400 billion) and borrowing from central banks ($380 billion) and used FX swaps ($800 billion) to convert (primarily) domestic currency funding into dollars.”

 

 

read more here:  http://blogs.cfr.org/setser/2009/03/08/the-shadow-financial-system-%E2%80%93-as-illustrated-in-three-new-papers-that-cut-through-london%E2%80%99s-fog/#

 

 

 

 

Challenges for the Euro:

 

see our discussion on the Euro

 

Note:  invstors are betting the EU has 20% chance of breakup due to deficits (?) "The bond yields of some European nations surged as governments planned to sell record amounts of debt in 2009 to revive economies battered by the global recession.  The 11 biggest economies in the euro region will increase government debt issuance this year by about 26 percent to 1.05 trillion euros ($1.38 trillion) from 830 billion euros in 2008, London-based Riccardo Barbieri-Hermitte, head of European rates strategy at Bank of America Corp., wrote in a report last month.

 

Investors are betting the euro region will struggle to contain budget deficits that exceed the 3 percent limit outlined in the Stability and Growth Pact. Fiscal deficits will reach 11 percent in Ireland, 6.2 percent in Spain and 3.8 percent in Greece this year, according to ING.

 

 

 

 

 

 

Stimulus Europe:

 

see also:  fiscal stimulus and crisis recovery 2009

 

Germany:

"Germany’s fiscal stimulus to 80.3 billion euros over two years, the Finance Ministry said. At about 1.6 percent of gross domestic product, that’s the biggest stimulus program in Europe"...The decision by Germany’s government to add a second €50 billion ($66 billion) stimulus package is a step forward, though at barely more than 1% of GDP it is still far too small (see article).

 

But to protect companies from potential defaults...Financial Times Deutschland on Wednesday reported that Berlin is weighing the establishment of a €100 billion ($132.7 billion) fund to provide German companies with liquidity should they run into refinancing difficulties. "We can't allow momentary difficulties to drive companies into bankruptcy," an unnamed conservative politician told the paper.

 

 

 

 

 

 

UK

U.K. Prime Minister Gordon Brown has proposed 500 million pounds ($734 million) to spur hiring and will outline measures tomorrow to ease lending for small businesses.

 

While not exactly a fiscal stimulus, the UK has plans to insure bank lending in attempt to get money flowing again.... proposing insurance to underwrite mortgage-backed debt and toxic assets and reversing plans to shrink Northern Rock Plc’s lending. ...The new measures would add at least 100 billion pounds ($149 billion) to the 250 billion pounds committed by Prime Minister Gordon Brown in October to underwrite a financial system choked with bad debt and reeling under the first recession in two decades.

 

France

French President Nicolas Sarkozy is preparing a second package for banks worth 10.6 billion euros and said Jan. 8 that he will emulate German plans to help companies borrow

 

 

 

Switzerland:

tiny stimulus package:  see Switzerland

 

 

 

 

European Debt Crisis - graphics

 

 

 

 

 

 

 

 

Footnotes

  1. http://blogs.wsj.com/marketbeat/2010/11/26/spain-what-are-its-funding-needs/
  2. http://blogs.wsj.com/marketbeat/2010/11/26/spain-what-are-its-funding-needs/
  3. http://www.bbc.co.uk/news/business-11924853

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