German Constitutional Court ruling may we force Euro Zone countries to defaut
Kiron Sarkar
September 11, 2011

Chinese inflation declined to +6.2% YoY, though food prices remain a serious problem. However, whilst inflation may spike in the next month or so, it appears to be declining. The PBOC is likely to be less hawkish, particularly given the slowdown in the global economy;

The Chinese August trade surplus shrank to US$17.8bn, from US$31.5bn in July. Exports rose by +24.5% YoY, higher than the +20.4% increase in July. However imports rose even faster - by +30.2% YoY, much higher than forecasts for an increase of +21%, mainly due to restocking by Chinese companies of raw materials. There have been many calls that the Chinese trade surplus will shrink and may even become a deficit. However, a lot of the products, exported by the Chinese, simply cannot be sourced through other countries, certainly at present, even if prices are increased - suggests to me that Chinese trade surpluses are here for longer;

Chinese lending rose by Yuan 548.5bn (US$85.9bn) in August, above forecasts for an increase of Yuan500bn. M2 rose +13.5% YoY, lower than estimates of +14.2%;

There have been endless rumours that Reliance, one of India's largest companies, has had a far too cosy relationship with the Indian Government. Reports released by the Comptroller and Auditor General ("CAG") state that the capex cost of gas production by Reliance Industries (controlled by India's richest man, Mr Mukesh Ambani) were US$8.8bn, much higher than the US$2.4bn estimate. OK, that's a problem for the company, you say. Well, not exactly. Most of the funds were paid by the Indian Government. In addition, Reliance was allowed to retain a number of acreages which they should have given up, according to the CAG report. BP has now agreed to take a stake in Reliance Industries - given BP's unerring talent to (well lets be polite) get it somewhat wrong, well......Whatever, increased focus on corruption in India will have a major impact on the performance of a number of Indian companies;

Christine Lagarde has been beaten up by European Finance Ministers for a report, produced by the IMF, which suggested that European banks needed some E200bn and Governments should force mandatory recapitalisation's of the relevant banks. Silly girl. The reality is that European banks will need far, far more, though the Euro Zone is, as usual, in total denial. This plan to deny (effectively lie) is getting very tedious indeed. Don't they know that markets are not that stupid;

Bloomberg reports that the ECB is to dilute its attempts to wean European banks off emergency funding (using higher interest rates). Essentially, the ECB will ask financial institutions (together with the relevant national Central Bank) as to how they intend to repay the funds. Well, that's a great plan. Does that suggest that they did not do even the most cursory of credit checks before they provided emergency funding !!!!. The reality is that the collateral received by the ECB is effectively toilet paper - certainly in respect of Greece, and they will face significant losses. How will they cope, given their extremely limited capital - well they could ask Euro Zone Governments to make up the loss (embarrassing), or they could print money.

The amounts involved are huge. Irish banks borrowed E97.9bn in August, Portuguese E46bn and (off course) the Greeks a staggering E103bn, as at the end of June - the latest data available and likely to have increased since then. However, Mr Trichet is exiting at the end of October this year and it will be Mr Draghi's problem thereafter. Now that's a real plan and very much in the Trichet style. I still cant forget his recent press conference where he stated that the ECB's performance had been "impeccable". When the inevitable chickens come home to roost, I wonder whether someone will replay that;

The Greek PM vowed that the country would meet its fiscal targets and to press ahead with structural reforms, involving, inter alia, the sacking of some 20,000 civil servants. There were violent protests at the speech. Greece cannot and will not deliver and the rest of the Euro Zone does not believe that they will. A default is a certainty and relatively soon;

Recent reports suggest that US money market funds have been reluctant to provide short term financing to European banks - no great surprise. Analysts suggest that European banks face a US$500bn dollar funding gap. The problem is that the cost to swap Euros into US$ has jumped fivefold (to 103bps for 3 month loans, from just 20bps in June). This extra cost is extremely serious for a number of European financial institutions. In addition, recent data also suggests that there has been a withdrawal of deposits by Europeans from European banks and the proceeds deposited with US banks (source FT). Just to add to the pressure, there are reports that the credit agencies (Moody's) will downgrade French banks imminently - BNP, Soc Gen and Credit Agricole were placed on review for a possible downgrade in June;

The impact of the recent ruling by the German Constitutional Court is likely to have a far more serious impact on the Euro Zone than suggested by the initial headlines. Essentially, it prohibits the German Government from accepting permanent rescue mechanisms if they a) involve a permanent liability to other countries b) if these liabilities are large or incalculable and c) if foreign governments can trigger payments under guarantees, as a result of their actions.

If this is the right interpretation, the EFSF is OK (however it ceases in 2013), but its replacement, the ESM (which is a permanent mechanism) is not. Furthermore, it also suggests that an Euro bond will fall foul of the ruling as they are permanent and will be large. In a previous ruling, the German Constitutional Court stated that any transfer of fiscal responsibility to Brussels would require approval through a referendum. In the current climate, the Germans will not vote in favour of such a possibility.

This ruling is the killer for the Greeks and, virtually certainly for the Portuguese, as well. They will have to default and restructure their debts. The Irish - well its touch and go, but if the global economy continues to weaken, it looks like they are in trouble too. The ruling also means that the ECB will remain the only player in town and they are extremely reluctant participants. In addition, European banks will need a lot more capital to meet losses on their holdings of sovereign bonds.

I suppose you could have a constantly rolling "temporary" mechanism, but that seems likely to be challenged. Another alternative could be unsterilised QE by the ECB, but that is an anathema to the Central bank. I will need to re check this carefully (given the extremely serious implications) but, on the face of it, it looks like being a real problem. The stakes have been raised sky high.

There are further reports that the IMF is raising funding. Normally a bad sign, as it suggests that they see a need (ie a Sovereign rescue?) for the funds;