Euro Stability Treaty - version 1000000000..........
Kiron Sarkar
November 27, 2011

Hi there,

Weekend reports from German newspapers and the WSJ, suggest that France and Germany are to propose a fast track mechanism which, if implemented, would put in place a tougher and integrated fiscal policy for all 17 Euro Zone members - a new "Euro Stability Treaty" (haven't we heard that before), to become effective by the beginning of 2012 - wow a speedy Merkozy - does that imply that they are getting worried? sounds like it, does it not.

Essentially, Euro Zone countries would by pass the EU (as the EU would take too long) and, essentially, enter into bilateral agreements with each other (as per the Schengen agreement, which scrapped passport controls within Euro Zone countries that signed up to it) to effect these new policies. The EU treaty allows for "enhanced cooperation", once at least 9 of the 17 Euro Zone countries agree - also means that it circumvents the need for all 27 EU member states to approve the changes ie the avoids problems with the UK, in the main, I suspect. By the way, how many bilateral treaties would that involve (answers please) - and yet its considered faster, than through the EU !!!!!!!

As an aside, the Schengen treaty is in disarray at present, as a number of signatories to that agreement have decided to take matters into their own hands - not a great precedent, I would have thought - I'm sure you wont hear that from the Euro Zone/EU.

These agreements, when entered into, would enable the Euro Zone to agree to fiscal measures, which would be much tougher than currently is the case and will be subject to verification centrally, by the EU - presumably with enforcement provisions and penalties for non compliance - basically goodbye Greece at the very least, if implemented - no great loss, I must admit.

Apparently, details of this new plan will be revealed, prior to the 9th December EU Summit. There are extremely serious issues about democratic accountability, the impact on non Euro Zone members, Ireland's corporation tax rate etc, etc, but hey when has the EU ever been a democratic organisation - its very structure, whereby non elected commissioners create laws, which are applicable to all 27 countries, is existing proof of that. Further evidence is the appointment of Technocrats in Greece and Italy - OK, the alternatives were awful, but you can hardly describe their appointment as democratic - though heralded by the Euro Zone as great news. Furthermore, the (so called) non political ECB is rumoured to have caused the exit of Berlusconi, by not buying Italian bonds, resulting in yields soaring.

There is a thin line, but the EU crosses it many many times for my comfort. These are a number of the very many reasons I have been and remain staunchly opposed to the EU, which I still believe should have remained just a free trade zone.

I cant help thinking that this new French/German plan stems from the realisation, by Germany, that, inter alia:

Germany is not immune from market forces - the recent failed Bund auction (by the way the 6th to date, as my friend Marc Chandler from Brown Brothers Harriman points out to me - by the way his and his teams reports, for mainly forex participants, are excellent - a must read); Germany is losing support from its allies Austria, Finland and Holland, who are getting mighty nervous as to Germany's hard ball tactics to date, particularly as they (and their banks, in particular) are being affected, to say the least; German banks are really feeling the pinch - very serious indeed, as most of them are grossly under capitalised.

I know, I keep banging on about the above issues, but, for a variety of reasons, I am now convinced as to the merit of the above 3 points.

The further downgrade of Portugal and, more importantly, Belgium, the home of the EU, are facts that Germany cannot ignore - basically the economic news is one way and that's southwards and, alarmingly, expanding to well within core Europe. The easier way to look at it is to follow those who have not been downgraded - a much fewer number. Prospective bond yields of the PIIGS - well think of a number (and probably double it), if this continues. Interestingly, Belgium having been deadlocked politically for over 1 year, suddenly produced a budget once they were downgraded - pure coincidence - I think not. Indeed, they may even form a Government - poor Belgium's - they were over the moon when free from politicians, as my Belgium friend Renaat tells me.

Furthermore and amusingly Germany, Holland and Finland have called for greater IMF involvement - lost faith in the EU - thought so. Personally, I remain of the view that the IMF has to be involved - Euro Zone institutions are not credible - one of the most serious market negatives around. The IMF has hinted at short term financing schemes, based on lending a multiple of recipients original capital subscriptions - likely to be implemented. Will provide some breathing space.

The myth (until recently) was that Germany was immune from the financial turmoil. Germany (and much more importantly, the markets) are beginning to understand that that is not the case. Indeed, the market smells blood and we all know what happens next. For example, a further rise in Bund yields (if, for example, investors believe that the threat to Germany from a disorderly break up of the Euro Zone and/or the likelihood that Germany will have to take on additional financial burdens, with the consequential severe adverse financial implications - which, in my opinion, is obviously the case) will place additional pressure on the country and on bund yields.

Lets, for the sake of an example, consider a German bank - D Bank. It's sitting on a lot of Sovereign debt, most of which underwater, with the exception of German Bunds, UK Gilts and US Treasuries (and is highly leveraged and, in addition, knows that regulators are going to impose rules which will force it to raise capital shortly). OK, they will reduce their foreign exposure and repatriate funds, fiddle risk weighted assets etc, etc - happening at present. Indeed, most analysts believe that Euro repatriation is one of the major reasons why the Euro has not tanked even more. By the way, reduced/a cut back in lending is very bad news for (capital hungry) EM's - the FT reported that European banks accounted for 21% of Asian/S E Asian loans. Basically, it means that EM interest rates in Asia/S E Asia will rise. US and Japanese banks may fill in part of the gap, but they will demand higher rates and lend only to the biggest companies, as will local banks.

However, lets return to D Bank and their holdings of Sovereign bonds - ignoring D Bank's holding of UK Gilts/US Treasuries for the purpose of this exercise. The European Banking Authority ("EBA"), I understand, has expressed a view, that unrealised gains on banks bond portfolios cannot be recognised (possibly will be changed to partial recognition) in assessing, in effect, capital adequacy, though losses must be fully accounted for. However, the EBA are using 30th Sept prices for the relevant banks bond portfolios ie before the recent turmoil - will they ever stop trying to fiddle the books.

These rules are still to be finalised, but banks have to achieve a core Tier 1 capital ratio of 9.0% by June 2012, I believe. Well, I, for one, would not be surprised if Bank D realises its gains, by selling its Bunds, thereby improving its ratios. Investors are increasingly concerned as to the state of the entire Euro Zone, including Germany, and German bund yields are not generous. Furthermore, the Euro is weakening. If Bund yields rise further, so will investor concern, resulting in, guess what, more selling of Bunds. The question is who are the buyers - any volunteers?

Ignoring the Sovereign debt financing requirements, European banks have and will have problems arranging medium term debt financing. As a result, I am certain that the ECB will provide medium term (2 year certainly and there has even been talk of 3 year) facilities - no great surprise - well leaked. However, for once, would it not be better for the ECB/EU/ECB to operate via formal press announcements, rather than the nudge, nudge, wink, wink policy they currently maintain.

Whoops. The above is far too far fetched you say. Well, over 1 year ago, people told me that my sceptical views on the fiscal position of Spain, in particular, and indeed, France were far fetched - case semi proven, I believe.

Germany's financial position is not wunderbar - sorry, probably buggered up the spelling. It does have great businesses model, fabulous companies etc, etc, but the global slowdown will impact its export driven economy, which represents approximately 50% of its economy. To date, domestic demand has held up, but the Germans are notorious for pulling back on spending in times of stress and strain and sure seems like S&S to me right now. Personally, I will not be surprised if Germany suffers a technical recession next year. Current 2012 GDP forecasts, which are declining and getting ever closer to zero, makes such a possibility likely.

Recent comments by Dutch, Finnish and even Austrians, confirm my view that they are getting mighty nervous. In addition, previous supporters of Germany are becoming more and more cautious and possibly even critical of the German position. OK, not a problem if it came from the Greeks - indeed, quite the reverse - but from the Dutch..........

Germany has been pushed into the headlights, internationally - not something it is accustomed to. The international community is watching every move. Sure Germany can ignore criticism (possibly longer than most), but not for too long. Criticism sticks and if the proverbial pooh hits the ever faster spinning fan, it will stick even more and on a far wider group - not a pleasant prospect for German politicians/officials.

A number of my German readers tell me I am wrong. However, reading between the lines, their main argument is that they (German's) consider that sticking to their kind of stability/hair shirt policies, even in tough times, is paramount, whatever the consequences. They clearly know their German countrymen, far, far better than I - but, whilst clearly true in the past, I would say maybe not this time around. I remain a firm believer that, in today's global economy, market forces will override national policies/dogma, particularly when a country is not as strong as may have been thought. If I'm wrong, don't bother to read further, but.........

It's time to speculate.

First Germany needs treaty changes - mainly to convince its population that it will not pay out endlessly and, in addition, that the lazy, good for nothing, useless etc, etc, Southern Europeans, in the main (though I suspect they also view the French with deep suspicion) must be brought to heel. However, Germans, I believe, understand that the Euro has benefited them enormously. They have seen, only too recently, what happened to the Swissy and what the Swiss authorities had to do. Whilst Germans may yearn for their beloved DM, I think that most rational German's understand it would be the kiss of death for their export driven GDP model - the Government certainly does.

Martin Wolf of the FT wrote a fantastic piece on this subject recently - he set out how Germany has benefited enormously from the Euro and why, in his (and I totally agree), a return to the DM is impossible, unless there is a catastrophic collapse of the Euro - even in this case, I think dreams of the DM are just that - nostalgia.

Germany is beginning to understand that it must act and act fast - hence the proposals to fast track fiscal measures, as described above. Whilst German's are becoming more market aware, though they still view markets as irrational and an Anglo Saxon plot to destroy their meticulously planned, process driven, ordered state. Numerous stories abound where Mrs Merkel asks her aides to explain the markets to her - silence follows !!!!!. In any event, clearly impossible. If any of us understood markets, we would all be on a beach somewhere doing far more interesting things. However, she is a scientist (a physicist, I believe) who really needs to understand and be fully briefed - she always masters her brief I understand - other politicians should take note - you will be amazed how much of the time they do not read their briefs and make policy "on the hoof". How markets work and operate - that is going to be an interesting brief and personally, I'm glad I'm not trying to write it. Anyway, good luck Mrs M - having said that I will probably find out that she will be teaching all of us soon - well I certainly need to be educated, according to many of you out there.

Assuming, tougher fiscal measures are, indeed, fast tracked, the next step involves Mrs Merkel trying to become Machiavelli - though personally, I would stick to Italian blood, rather than E German - they have far far more experience and practice. Her coalition partners are convinced that she is just pushing through the (fast track fiscal measures described above, for example) treaty changes to placate the public and, in the end will give in, to ECB bond buying/QE/Euro bonds - they are right to, because, I suspect that's exactly her plan, to be accomplished sooner rather than later. OK, so my German readers now know I'm nuts. In addition, what you say, the ECB is independent and indeed, has proven to be staunchly independent. Come now. Politicians can CHANGE THE ECB MANDATE - an old trick, but the old ones remain the best. Before I get numerous emails, I am perfectly aware of Mrs Merkel's recent comments re non interference with the ECB - convinces me even more of my view.

A number of commentators point to the German Constitution/Constitutional Court. A friend of mine sent me a report on this issue - must read it again, but , if i recall, it suggests some flexibility. However, a German referendum is certainly a possibility in due course, as are Parliamentary votes/referendum in other Euro Zone countries. Will the German's vote in favour of stricter and enforecable fiscal measures - off course they will. They are unlikely to be told of the subsequent plan though - maybe this is just unwarranted speculation on my part. Will other countries, well what other choice have they. Are they deliverable - ah, well that's the question.

The continued uncertainty will weigh on markets - personally, hands up, I have been far too early, though I remain of my view that you will have ECB bond buying/QE by the ECB (probably, post the enactment of the above fiscal measures) and indeed (I am now of the opinion, even sooner rather than later thereafter) Euro Bonds. I accept that I'm fast becoming a minority of 1 (if I'm not there already), but I really cant see any other way, except for a break up of the Euro Zone and I suspect that option remains verboten - German is not my strong point as you will notice - I trust it does not extend to my views of the German people/policy. However, even Germany wants the Euro Zone to survive.

Finally, the increasingly obvious conclusion that the EFSF is a "dead duck", is doing the rounds in the Euro Zone - the Dutch Finance Minister recently stated that if the EFSF was a non starter, other means (read ECB bond buying/QE) should be considered. I generally follow the Dutch, who I consider one of the most (only?) sensible countries in the Euro Zone.

Before I finish off on the Euro Zone, markets on Friday rallied (a bit) on speculation that banks would not have to take further hits on their holdings of Sovereign bonds. What nationalise private sector losses again. Surely Ireland showed exactly why that is clinically insane - even before one addresses the moral hazard issues involved.

Everyone is focusing on the Euro Zone right now.

However, interesting developments in China, the remaining Bric's and the US and UK.

I remain bearish (and increasingly so, if that is possible) on China, even though I suspect that the authorities will loosen monetary policy - some smaller banks have had their RRR loosened - I would expect that RRR's for the larger banks will be relaxed as well. Economic data is trending one way and that's southwards. It is assumed that the Chinese Communist Party will want a smooth transition to the new regime next year. However, housing bubbles abound (personally, even the authorities know it, I believe), social tensions rise (increasing riots), local authority finances are a complete mess (they rely on property sales, which have collapsed both in terms of price and volume), talk about major financial difficulties for all (other than politically connected) companies, slower exports (certainly to the fast slowing Europe - China's main trading partner), over reliance on fixed asset investment for growth, not enough pick up in domestic consumer demand, forecasts for a zero trade surplus, some say a deficit, within 2 years, bust banks, etc, etc. The list is endless and I have bored you with it for a very long time. However, the situation is deteriorating, in my humble opinion.

However, the key issue once again - capital flight from China is ever increasing and at a much faster rate - generally, pretty good evidence of serious prospective problems. I'm fast coming to the view that the Yuan may actually be overvalued.

Russia, well Putin is acknowledged by boos nowadays - the deal with Medvedev (where they switch jobs) is not popular. It's all because of plots by foreigners Putin says - come on, not that old line. Whilst Putin is expected to win the forthcoming Presidential elections in 2012, polls suggest his majority and that of his party, will be reduced significantly. Oil has to remain at near US$100 to support the bribes (oops sorry - the forward thinking socially beneficial, brilliantly executed...........someone might be reading this, poor person). Evidence of capital flight (increasing) is even acknowledged by the authorities.

India, well I'm here at present and my well informed friends are nervous - when they get nervous, watch out. One issue, India, like China, is not allowing utilities to pass on much higher coal prices in electricity prices - to help control inflation. The problem is that the utilities are reducing production - there have been even more power cuts than normal. The new plan is to stop coal suppliers from raising prices - yeah, we all know what happens next. The Indian Rupee - well, its performing badly - is it the worst performing in the region - I must check. On the political front, India cancelled a scheduled meeting with China on discussions involving border disputes - the Dalai Lama is cited as the reason - however, not good news.

Brazil. Andy Lees of UBS reports that bad loans re Brazilian banks are rising fast - well what a surprise, when credit card debt costs 250%+ per annum and people buy on credit - indeed, they are encouraged to - retailers make more money on the financing, rather than the profit on the sale of the particular item. Recent policy confirms that the Government is deeply worried. Personally, I believe the current situation is a hangover from Lula's expansionist policies. Anyway, a very good friend of mine like the statistic's in Brazil, though his stats lie on Copacabana beach - I would also be impressed. (By the way, is this the time to remind you that Santander has a major banking operation in Brazil. Another issue, Santander, recently put the squeeze on some of their debt holders - generally considered a no no as you wont have buyers of your debt the next time round. Could it be that they need capital - off course it is).

The bottom line is, once again, EM's are NOT DECOUPLED. Thanks Mr O'Neill, but no thanks.

On the other hand, US data continues to be positive - yeah, I know GDP was revised lower, but inventories were a main reason - suggests to me that it will correct in future months. On the downside, the ending of accelerated tax allowances, Bush tax cuts and possibly even payroll taxes, will act as a drag next year. However, the biggest issue is the political logjam - if it was not for the Euro Zone news, it would be headline news I guess.

The UK, well, I'm sorry to say that the economic data continues to weaken - a 2012 recession is a near certainty.

The Middle East is being ignored - dangerous. My friend Robert Hardy produced, amongst other articles, yet another excellent report on Syria/Iran in his GEOSTRAT publication - GEOSTRAT IS a must, must, must read.

Gosh, I need a stiff drink after the above - I suspect you do to.

Best
Kiron