October 25, 2011

Crossing a Watershed, Unawares

By PAUL KENNEDY


A watershed is, by Webster’s definition, an aspect of physical geography: an area bounded by water parting and draining down a particular course. The water to the north of this divide runs in one direction, the water to the south of the divide runs the opposite way. But for centuries the term has also been used to describe a historical and political phenomenon: that is, when an array of existing human activities and circumstances pass, irrevocably, from one age to the next, across a great divide.


At the time, very few contemporaries sense that they have entered a new era, unless of course the world is coming out of a cataclysmic war, like the Napoleonic wars or World War II. But such abrupt historical transformations are not the focus of this article. My interest is in the slow buildup of forces for change, mainly invisible, almost always unpredictable, that sooner or later will turn one age into another.


This topic of “watershedscrops up frequently in a weekly discussion class I am holding with eight Yale students this semester. The class was not originally meant to focus on that problem, but it has emerged that way. The first book we read was Jan Huizinga’s classicThe Waning of the Middle Ages,” an elegiac look at the end of a centuries-long period in Western history. Then we grappled with books on Europe’s early outward push (Carlo Cipolla’sGuns, Sails and Empires: Technological Innovation and the Early Phases of European Expansion, 1400-1700”) and the brutal Reformation in England (Eamon Duffy’sThe Stripping of the Altars”). When we put these books together, we realized that we had been looking at a watershed era of massive proportions. No one alive in 1480 would recognize the world of 1530 — a world of new nation-states, Christendom splintered, European expansion into Asia and the Americas, the Gutenberg communications revolution. Perhaps this was the greatest historical watershed of all time, at least in the West.


There are other examples, of course. Someone living in England in 1750, before the widespread use of the steam engine, would have been staggered at its application 50 years later: The Industrial Revolution had arrived!


Some transformations from one era to another have an even shorter life cycle, such as in that epic period between 1919 and 1939. Democracy was fraying by the early 1930s, the world economy was rotting, but who sensed it would lead to war and holocausts? As the great Cambridge diplomatic historian Dr. Zara Steiner asks: “When did people know they were no longer in a post-World War One era, but in the approach to the Second World War?” The answer is that only a very few suspected it, and many came later to the new reality. They were in a new age.


So what about today? Many newspaper correspondents and technology pundits point excitedly to our ongoing communications revolution (cell phone, iPad and other gadgetry), and to its impact upon states and peoples, upon traditional authorities and new liberation movements. The evidence for this view is clear across the entire Middle East, and even in the very tameOccupy Wall Streetmovement, although one wonders if any of the high-tech prophets proclaiming that a new era in world affairs has arrived have ever bothered to study the impact of the Gutenberg printing press, or of F.D.R.’s radio chats to tens of millions of Americans in the 1930s and early 1940s.


Each age, then, becomes mesmerized by its own technological revolutions, so I am going to focus upon something rather different: indicators of change that suggest that we are approaching — or may even have crossedcertain historical watersheds in the hard worlds of economics and politics.


The first of these is the steady erosion of the dollar as the planet’s sole or dominating reserve currency. Gone already are the days when 85 percent or more of international currency reserves were held in “greenbacks”; the statistics fluctuate wildly at present, but the figure is now closer to 60 percent. Despite the economic woes of Europe and even China, it is no longer fantastic to imagine a world of three large reserve currencies — the dollar, euro and yuan — with a few smaller outliers like sterling, the Swiss franc and the yen.


A blinkered American economist or investment adviser who does not recognize that the times are changing is probably going to do himself and his clients a considerable disservice. The simplistic notion that people will fly to the dollar as a “safe haven” is put into question by the country’s increasingly surreal indebtedness to foreign lenders. And will a world of various reserve currencies make for more, or less, financial stability?


The second transformation is the erosion and paralysis of the European project, by which I mean Jean Monnet and Robert Schuman’s dream that the heterogeneous European nation-states would steadily come together, first through commercial and fiscal integration, and then by serious and irreversible commitments to a politically united continent. The institutions for realizing that dream — the European Parliament, the European Commission, the Court of Justice — are already in place, but the political will to breathe real life into them is gone, sadly undermined by the simple fact that wildly divergent national fiscal policies are incompatible with a common European currency.


Bluntly put, Germany and Greece, with their separate budgetary records, cannot march together toward a United States of Europe; but no one appears to have an answer to this dichotomy, except to paper over the cracks with further tranches of Euro-bonds and I.M.F. loans.


The Europeans, in other words, have neither the time nor the energy nor the resources to focus on things other than their own problems. This means that there are very few observers across that continent who have studied what might be the third great transformation of our times: namely, the enormous arms race that is occurring in most parts of East Asia and South Asia.


While European militaries become more like local gendarmeries, Asian governments are purposefully developing deep-water navies, building new military bases, acquiring ever more sophisticated aircraft, and testing missiles with ever longer ranges. What discussion has occurred focuses on China’s military buildup, and rather little on the fact that Japan, South Korea, Indonesia, India and even Australia are following suit.


What do Asian nations apprehend about the future of the world that European governments are now oblivious to? If slower economic growth, environmental damage and a fraying social fabric in China lead its future leaders toward muscle-flexing abroadright now, it is fair to say, China’s leaders are quite cautious — its neighbors are planning a firm response. Does anyone in Brussels know, or care, that after 500 years of history, the world of 1500 is at an end? Asia advances to center stage, while Europe becomes a distant chorus. Won’t future historians regard this phenomenon also as an amazing watershed in international affairs?


The fourth change is, alas, the slow, steady and growing decrepitude of the United Nations, and especially of its most critical organ, the Security Council. The U.N. Charter was carefully crafted to help the family of nations enjoy peace and prosperity after the horrendous evils of 1937-1945. But the charter itself was a calculated risk: recognizing that the Great Powers of 1945 would have to be given a disproportionate role (like a permanent Security Council seat and the veto), the drafters nonetheless hoped that those five governments might work together to realize the world body’s high ideals.


The Cold War killed such hopes, the collapse of the Soviet Union revived them, but now they are fading again due to the cynical abuse of the veto power. When China and Russia veto any measure to stop the Syrian regime of Hafez al-Assad from killing its own citizens, and when the United States vetoes any resolution to stop Israel from advancing into Palestinian lands, the world organization is made redundant. And Moscow, Beijing and Washington seem to like it that way.


The waning of the dollar’s heft, the unwinding of European dreams, the arms race in Asia, and the paralysis of the U.N. Security Council whenever a veto is threateneddo not these, taken together, suggest that we are moving into new, uncharted waters, into a troubled world compared with which the obvious joy of customers emerging from an Apple store with an updated device look, well, of limp and secondary significance?


It is as if one were back in 1500, emerging from the Middle Ages to the early-modern world. The crowds at that time were marveling at a new and more powerful longbow. Surely we can take our world a bit more seriously than that?


Paul Kennedy, Dilworth Professor of History and director of International Security Studies at Yale University, is the author of many books, including “The Rise and Fall of the Great Powers.”
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TRIBUNE MEDIA SERVICES


China signals irritation as Europe stares into the financial abyss
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Europe's grotesque debt crisis rumbles on. France and Germany are at daggers drawn, the eurozone's two largest economies still a million miles away from agreeing on how they intend to patch-up what is, and always has been, an utterly incoherent economic construct.

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In a rare public outburst this week, China's Wen Jiabao said Europe's leaders should 'turn their political will into action'. By Liam Halligan
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9:30PM BST 22 Oct 2011
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The burden of bailing-out moribund banks, and peripheral eurozone nations, means France is on the verge of losing its "Triple-A" credit rating. Given the crucial role of the world's fifth biggest economy in holding the single currency together, a Gallic downgrade could be the final straw.


The spread over its German equivalent, having more than tripled since mid-summer, is now twice as wide as in the immediate aftermath of the Lehman collapse. The alarm bells are ringing extremely loudly.


"The outside impression is disastrous," observed Jean-Claude Juncker, the Prime Minister of Luxembourg. "It doesn't appear a bright example of superior statesmanship and in the future we will have to talk about how to transform the view that others have of us."


Too true, Jean-Claude. Except that "the future" is now.


The euro was never going to work. Yet the eurocrat elite – which includes Mr Juncker down to the tip of his Mont Blanc penarrogantly ignored all the signals. Those of us who objected to monetary union on technical grounds, who warned of bitter conflict, who recalled the lessons of history, were dismissed as "xenophobes" and "cranks".


And now, having used Western Europe as an economic laboratory, the single currency's architects need to admit that their hubristic experiment has gone very badly wrong.


Decisive action is needed to stabilise financial markets. It should also be made clear, though, that the single currency will be scaled-back in the medium-term, possibly with a view to total break-up. If that sounds drastic, we're now in a drastic situation. Those of us calling for such an outcome will doubtless be dubbed "crazy", not least by the same self-serving officials and financial institutions who derided our objections to the euro's initial formation.


If the likes of Juncker had been as honest and straight-talking 20 years ago as they profess to be now, we wouldn't be in this mess. The mess, of course, goes way beyond Europe. International concern about the fall-out from a possible "euroquake" means the time for diplomatic niceties has gone and the rebukes are now coming from all angles.


On Friday, in a rare public outburst, China's Wen Jiabao said Europe's leaders should "turn their political will into action". Beijing wants to see decisive measures to prevent Europe's debt crisis from spreading, with all the global market turbulence that would bring.


Global investors have been keeping a wary eye on China, amid concerns the second-largest economy on earth could be heading for a "hard landing". Having replaced the US and Europe as the world's economic locomotive, China's condition now helps shape global economic sentiment. Last week, we learnt that while Chinese growth moderated during the third quarter, GDP still expanded 9.1pc. Inflation, meanwhile, having recently hit a three-year high, fell to 6.1pc in September, down from 6.5pc in July.


Faced with signs of over-heating, Beijing has raised interest rates five times and hiked bank reserve requirements nine times in the last year. China now looks on track for a "soft landing", combining cooling prices with on-going rapid growth.


While this is good news for the rest of the world, the world seems determined not to see it that way. The US Senate is now considering a bill that seeks to "punish" China for "manipulating" its currency. With unemployment above 9pc, despite median wages now lower in real terms than in 1999, American politicians are once again looking for scapegoats.


In the US, and other "advanced countries", we could do a lot to improve our economic plight. We could try raising productivity, for instance, while reining-in the destructive behaviour of our banks. Complaining about a weak yuan isn't going to help us one bit, for all the claims that China is "stealing Western jobs" by keeping its currency low.


Since the renminbi was unpegged in June 2005, it has risen 25pc against the dollar, more in real terms given higher Chinese inflation. Lots of items supposedly "made in China" are, anyway, merely assembled in China – the component parts often coming from high-wage Asian economies such as Japan and South Korea.


So the "slave labour" argument we often hear in Congress is nonsense, not least as the "slaves" themselves, hundreds of millions of rural Chinese who've trekked to the city in recent decades, have done so freely, in search of work and a better life.


It's not as if dearer Chinese exports would create jobs in high-wage Western economies. A less competitive China would simply mean that even lower-wage nations such as Indonesia and Vietnam gain market share. That's happening anyway, seeing as the gap between Chinese manufacturing wages, up ten-fold over 20 years, and those in the West, is rapidly getting smaller.


No matter what the evidence, US lawmakers are desperate to attack the "cheating" Chinese. Under the draft law, the Treasury Department produces a twice-yearly report naming "significantly under-valued" currencies, the nations so identified then facing sanctions on their exports to the States.


This Bill is reckless, economically illiterate and risks sparking a fully-blown trade war between the world's two-biggest economies – just what we need at a time like this. America needs to recognise that the yuan has risen faster in the last 6 years than any other large emerging market currency. The louder Congress calls for China to revalue faster, the longer Beijing will take. Chinese politicians are as unlikely to buckle in the face of Western pressure as their Western counterparts would be, given a tongue-lashing from Beijing.


Away from the Sino-US trade spats, and the euro rollercoaster, the development which really caught my eye last week was a deal signed by China and Russia. The two emerging giants agreed to launch a joint development fund, with China investing more in its vast Slavic neighbour in a single swoop than it has since the Soviet Union collapsed in 1991.

The People's Republic, sitting on $3,200bn of reserves, is awash with cash it wants to invest. But the Chinese are nervous, not only about their energy security but also about further exposing themselves to Western currencies that are being deliberately debased. Russia, meanwhile, wants to diversify away from European markets that are showing increasing signs of long-term economic stagnation. So commercial co-operation between Russia and China makes sense. Trade between the two nations, having risen more than ten-fold over the last decade, is now accelerating even faster.


There seems to be a hope in some European capitals, meanwhile, that China's angst over Europe's "euroquake" means Beijing is about to ride to the rescue. I don't think so. The Chinese government's earlier disastrous investments in various Wall Street banks have been the subject of bitter internal criticism. Is a country without a welfare state really going to bail-out nations whose welfare states are bloated and out of control? It's a pretty tough sell.


"We need to see systematic and fundamental fiscal and financial reform in Europe," said Wen on Friday. "This will demand extraordinary political courage and judgment".


So what are the Chinese really saying? I think they're saying that if the Eurocrats want Chinese money, they'll either need to construct a fiscal union (which is impossible) or move to break the eurozone up.

The writing, you might say, is on the Great Wall.



Liam Halligan is chief economist at Prosperity Capital Management.


October 25, 2011 8:30 pm

Dexia brought to a halt



Pierre Mariani was desperate to raise cash. The eurozone crisis had made investors shy away from lending to just about any European bank in recent months, but Dexia, the Brussels-based financial group where he was entering his fourth year as chief executive, was finding it even more difficult.
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International lenders that provided Dexia’s day-to-day liquidity had become so spooked by its €21bn ($29bn) portfolio of Greek, Italian and other peripheral eurozone government bonds that they were increasingly reticent to supply further financing.
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But Mr Mariani, a bespectacled Corsican who once served as French president Nicolas Sarkozy’s top aide, had a lead that could give it at least a temporary respite: a group of Qatar-based investors appeared ready to make a quick purchase of the bank’s Luxembourg-based banking arm. The cash from the sale – perhaps €1bn of it – was not a permanent solution but would give Dexia breathing room.
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On the Friday before flying to the Qatari capital Doha, Mr Mariani and his top lieutenants received the news they were all dreading: Moody’s Investors Service, the credit rating agency, was considering a downgrade of Dexia’s bonds.
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The next day, Saturday October 1, Mr Mariani headed for Doha anyway for a 36-hour effort to clinch the deal. It was a long shot: the Qatari option had surfaced only two days before, pushed by Luxembourg authorities eager to see a bank on their territory transferred to a more stable parent.
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That is how Mr Mariani, a product of France’s elite civil service finishing school brought in to save the bank from near-collapse in 2008, found himself in a lounge at Doha’s antiseptic international airport waiting for a 2am Monday flight back when he received the call that told him his efforts would fail. Moody’s was to announce its review of Dexia debt before markets opened that morning.
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What happened to Dexia – its inability to raise liquidity because of its exposure to increasingly distressed eurozone sovereign bonds – is now gripping larger, more systemically important banks across Europe. The fear that Dexia is simply the canary in the coalmine – the sickest but not the only unhealthy bank trapped by a slow-moving credit squeeze – has been the biggest motivator pushing European Union leaders finally to attempt a system-wide rescue for their banks and bigger sovereign bond markets. That is the goal they hope to reach at today’s summit in Brussels.
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“The banking industry as a whole has come under clear pressure as a result of the eurozone crisis: fears around banks’ exposure to peripheral eurozone debt made investors weary of leaving their money [lent to] banks,” says Robert Law, an analyst at Nomura. Dexia was a pretty extreme case because it relied heavily on wholesale funding, but the longer funding difficulties go on, the more banks are threatened.”
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Dexia’s own top cadre insists that the reforms started in 2008 could have turned it into a “normalbank given another three years. “If the markets had stayed stable, we would have made it,” says one member of its executive committee. For European leaders, that may provide some hope. Perhaps Dexia was an anomaly and not the first of a series of toppling banks that governments are hoping to restore to soundness by a EU-wide recapitalisation scheme.
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Indeed, Dexia in some ways bears little resemblance to traditional lenders. Born of the merger of French and Belgian municipal lenders in 1996, it is majority owned by publicly controlled institutions in the two countries. Its governance reflected this: of nine French board directors, Mr Mariani is among seven graduates of the elite École Nationale d’Administration in Paris. The nine Belgians include Jean-Luc Dehaene, a former prime minister, as chairman. Only two of the 16 non-executives have private sector banking experience.
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But Dexia was also an anomaly in 2008. Still, in the weeks and months that followed, some of its supposedlynormallarger rivals followed it into bail-outs and nationalisations. Whether the pattern repeats itself is the question that torments Europe.
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To be sure, Dexia’s problems were worse than most. It had gone through a period of wild expansion until 2008 and, despite a restructuring Mr Mariani imposed when he took over that October, by this year it still required €100bn of short-term financing to plug gaps in its balance sheet.
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Though the amount was down from €260bn three years earlier, filling the void was becoming harder as the debt crisis spread to larger eurozone members such as Spain and Italy.
Every weekday, a 6pm conference call of its most senior managers tracked the progress of the bank’s treasury team as it battled to secure a daily €10bn-€20bn in funding from the wholesale markets. A downgrade – or even the hint of one – would shut that avenue for months. Just as in 2008, Dexia would be starved of cash.
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Mr Mariani’s weekend dash to Doha was not without hope; he had fended off Moody’s in the past. On the Friday night before he left, he had told the rating agency he would do whatever it took to avoid being the first banking victim of the eurozone crisis, and the Qatar meetings were about exactly that. An appeal against a downgrade had worked just a few months before.
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But Moody’s was not to be placated this time. After the Monday announcement, Dexia’s 18 directors convened. In their 33rd-floor boardroom overlooking the modest Brussels skyline, they decided that even a rapid sale of healthy assets could not plug the liquidity gap. A day later, the governments of France and Belgium stepped in to guarantee up to €90bn of short-term funding; Belgium then nationalised the bank’s operations on its turf. Long-cherished plans for renewed independence were dashed.
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Dexia’s primary business was staid, offering long-term loans to businesses and municipalities. But in the three years before its first near-death experience, the bank had boosted its profitability by relying on cheaper short-term financing in the wholesale markets. It reinforced the effect by purchasing long-maturity bonds using short-term borrowings.
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By the time of its 2008 bail-out, 43 per cent of its balance sheet was financed by short-term loans, compared with single-digit percentages for a typical bank. Such an imbalance is known to be risky: Northern Rock, the British mortgage lender, failed in 2007 for much the same reason. The practice will be banned under incoming Basel III banking regulations as a threat to banks’ stability.
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In a May interview with the Financial Times, Mr Mariani said that when he took over Dexia, the bank was like a “hedge fund of rates”: it played on the spread between long-term and short-term interest rates to generate returns. His task, he said, was to de-risk Dexia on behalf of its state shareholders, which directly and indirectly controlled three-quarters of its shares.
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Despite Dexia’s peculiarities, however, it was brought down by the same forces currently shaking the entire sector. Nearly every big bank has been having problems in raising financing to run its normal operations. So-calledterm markets”, which banks tap for loans extending from two to five years, all but closed from June to September. Only this month have the most solid lenders, such as HSBC and Deutsche Bank, again been able to raise funds that way. “These markets work best when everyone is happy with the world,” says Jeremy Sigee, a Barclays analyst.
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Shorter-term markets, while still open, have become gummed up as lenders such as big US money market funds, which control the deepest pools of cash, grew wary of lending to European banks. Stress tests imposed by regulators – which identified Dexia as one of the continent’s safest banks as recently as Julydid little to alleviate concerns, since those did not test for large writedowns on sovereign debt.
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An increasing number of private sector lenders, including Dexia, turned to the European Central Bank for liquidity, accepting the higher costs entailed in borrowing from Frankfurt. Dexia’s use of ECB facilities swelled from €17bn in April to €40bn in early July, a figure constrained only by the amount of collateral it was able to offer in return for the loans. Overall liquidity provided to European banks by the ECB topped €500bn in August. The authorities were keeping large sections of the banking system afloat.
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One way banks can find cash for operations is through normal profits made on their business. But there, Dexia was also suffering. On August 4 it posted second-quarter losses of more than €4bn, weighed down by the restructuring plan. The afternoon of that announcement, Dexia’s French-dominated management prepared for their normal summer holiday. “We were drained, exhausted,” says one senior executive. “The idea is that August is the best period to take time off because nothing happens.”
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But August would prove the cruelest month. The next day brought shock waves when Standard & Poor’s stripped the US of its triple A credit rating. In addition, a second €109bn bail-out for Greece, agreed in July by European leaders, began to unravel as markets came to understood how rosy the assumptions were that underpinned it. The Greek rescuehelped us for maybe two weeks”, says one Dexia executive. “Then it was back to crisis-as-usual.”
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The very volatility of the markets began eating away at Dexia’s limited cash reserves. Investors started piling their money into safe havens such as German bonds, driving down interest rates even though markets had been expecting an inflation-driven rise.
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For a “hedge fund of rates”, as Dexia still was to some extent, the implications were profound. The interest rate swing did not make an impact on its profits, as a result of equal-but-opposite hedges taken out to that effect. But the complex hedge itself became a problem: it required ever-growing amounts of cash to keep it going. The bank had to put up an extra €130m in collateral for every basis point that long-term interest rates dropped. By early October, an extra €16bn was needed. It was money it neither had nor could borrow.
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Dexia is now going through what amounts to an insolvency process: whatever healthy assets it owns, including the Luxembourg unit, are being auctioned to finance a “bad bank”. Its market capitalisation is down to around €1bn, from €29bn in its heyday. “It is not the outcome I would have wished for,” Mr Mariani told a Belgian newspaper last week.
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An adviser to one of the parties involved in Dexia’s collapse says it is now clear souring markets and the need for capital pushed Dexia past the point where a bail-out was inevitable weeks before the Moody’s warning.
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“This idea that they could sell enough assets to provide the money needed to muddle through – it was pure fantasy,” the adviser adds. “It should have been obvious by early September that a large intervention was needed. The moment traditional funding routes closed up, Dexia’s life was measured in weeks.”
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Business turns to bond markets
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There are mounting signs that France’s banking turmoil could be creating a lending squeeze, causing companies to rush to bond markets, write Robin Wigglesworth and Tracy Alloway.
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For their part, some French executives say they are not worried about domestic lenders, and have turned to debt markets only as part of a general move towards relying less on bank financing. “This trend isn’t specific to France,” says Gilles Bogaert, managing director of finance at drinksmaker Pernod Ricard, which issued a $1.5bn bond last week. “Companies across Europe want to rely less on bank debt.”
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However, the extent of French bond issuance – particularly in September, when French companies sold almost $13bn, accounting for a large majority of eurozone issuance – has raised the eyebrows of investors and bankers. “It’s pretty spectacular,” says Marco Baldini of Barclays Capital. “If it wasn’t for the French corporates, we would have very limited issuance in Europe.”
Some analysts maintain that heavy French bond sales are linked to concerns that domestic funding conditions will become tighter, given pressure on the country’s banks to prune their balance sheets. BNP Paribas, Société Générale and Crédit Agricole, the biggest listed lenders, will need to shed €600bn-€ 800bn worth of assets, according to UBS far more than BNP Paribas and Société Générale have signalled they may offload as they grapple with higher funding costs and potential recapitalisation. “It will come cheap to neither the domestic economy nor banks,” argues Omar Fall of UBS, noting that the lenders may even have to shedstrong franchises” such as corporate financing.
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According to the Banque de France’s latest survey, standards for lending to businesses tightened significantly in the third quarter. Further tightening is expected in the final quarter, Deutsche Bank said in a recent research note.
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While French lenders are overwhelmingly likely to continue to back blue-chip domestic companies, who provide them with many income streams, there are concerns that smaller entities could feel a squeeze.
Groups like us, that have a global footprint and a leadership position, are attractive clients for banks, but they will possibly be more careful with smaller companies,” Mr Bogaert concedes.
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Copyright The Financial Times Limited 2011