The ECB must step in to save the eurozone

George Soros

November 21, 2011

The current turmoil in the eurozone bonds markets shows striking parallels to the situation in autumn 2008. Then, bank depositors had lost confidence in the stability of the institutions holding their assets, and the threat of a bank-run could only be avoided by comprehensive government guarantees for all banks. Today, we are observing a bond-run: a self-fulfilling crisis of confidence in the stability of most eurozone sovereign borrowers.

This is driving long-term rates up, so that for more and more countries a temporary liquidity problem is becoming a permanent solvency problem. As regulators still treat government bonds as the safe core of the financial system, this vicious circle threatens the stability of financial institutions not only in the eurozone but also in the rest of the world. It intensifies the recessionary tendencies in the global economy so that in turn the financial situation of governments becomes worse. It’s a perfect vicious circle.

It can be broken only by stopping the bond-run as soon as possible. One way out would be a joint liability for the debt of eurozone members. But as the reaction of Angela Merkel’s government to a recent proposal of the German Council of Economic Experts has shown, the prospects for such a solution are not very good.

An alternative is the Soros plan as outlined in the Financial Times on October 30. The authorities could use the Emergency Financial Stability Fund to enable the European Central Bank to act as a lender of last resort without violating its statutes. The ECB would provide practically unlimited amounts of liquidity while the EFSF guaranteed the ECB against the solvency risks that it would incur. Acting together, they could resolve the liquidity problems facing the banks, and enable fiscally-responsible governments to issue treasury bills for less than one per cent.

Unfortunately the policymakers have not even started to consider this plan seriously. They originally envisioned the EFSF as a way of guaranteeing government bonds. They would have to reorient their thinking if the EFSF were to be used to guarantee the banking system. In July, when the EFSF was first proposed, it would have been large enough to take care of Greece, Portugal and Ireland. Since then, contagion has spread to Italy and Spain and the efforts to leverage the EFSF have run into legal and technical difficulties.

Since the Soros plan would take some time to prepare, in the interim the ECB is left to deal with a rapidly deteriorating situation on its own. On Monday the Bundesbank’s president questioned the right of the ECB to act as a lender of last resort. On Tuesday contagion spread to the rest of the eurozone. The financial markets are testing the ECB and want to find out what it is allowed to do.

It is imperative that the ECB should not fail that test. The central bank must stop the bond run at all costs because it is endangering the stability of the single currency. The best way to do it in the near term is to impose a ceiling on the yield of sovereign bonds issued by governments that follow responsible fiscal policies and are not subject to adjustment programmes.

The ceiling could be initially fixed, at say 5 per cent, and lowered gradually as conditions permit. By standing ready to buy unlimited amounts the ECB would effectively turn the interest rate ceiling into a floor from which bond prices would gradually rise without the ECB actually having to buy unlimited amounts. That is what the Swiss government did successfully when it tied the franc to the euro at 120.

Normally central banks fix only short-term interest rates but these are not normal times. Government bonds that were considered risk-free when financial institutions acquired them, and are still treated as such by the regulators, have turned into the riskiest of assets. Italian and Spanish bonds are viewed as too risky to buy with a yield of seven per cent because they are regarded as toxic, and the yield could just as easily rise to ten per cent. Yet the same bonds would be attractive long-term investments in the current deflationary environment, at say four per cent, as long as the excessive risk is removed by imposing a five per cent ceiling on interest rates.

The recent bond-runs have developed because the authorities hold sharply clashing views on the propriety of bond purchases by the ECB. The Bundesbank has been and remains vociferously opposed. But the deflationary threat is real and is beginning to be recognised even in Germany.

The statutes of the ECB call for the maintenance of price stability and that requires equal diligence with regard to inflation and deflation. The asymmetry is not in the statutes of the ECB but in the minds of Germans who have been traumatised by hyperinflation. However, the board of the ECB is an independent authority whose independence has to be respected even by the Bundesbank.

The interest rate ceiling should be regarded as an emergency measure. In the medium term it could encourage politicians to abandon fiscal discipline. In Italy, for instance, Silvio Berlusconi will be waiting for Mario Monti to trip up. Therefore the breathing space gained by imposing it should be used to establish appropriate fiscal rules and to devise a growth strategy that would enable the eurozone to grow out of its excessive indebtedness.
Peter Bofinger is professor of economics at Würzburg University. George Soros is chairman of Soros Fund Management and a philanthropist.

Response by Raoul Ruparel

Greater intervention by the ECB raises more problems than it solves

George Soros and Peter Bofinger present a measured approach for the intervention of the European Central Bank in eurozone bond markets, essentially envisioning it as a temporary liquidity provider of last resort. However, the ECB is already playing this role to a large extent. It has along with the eurozone bail-outs bought European politicians 18 months in which to devise the fiscal rules and growth strategy the authors call for. Unfortunately, leaders have repeatedly failed to reach any semblance of consensus on a lasting solution to the crisis.

Therefore, the exit strategy envisioned here for the ECB is dubious. Without a clear mechanism for winding down the ECB bond purchases, it becomes impossible to imagine a situation where the ECB could end its bond buying programme without causing huge market distortions.

The authors approvingly cite the example of the unlimited liquidity provision given to banks. However, this could equally be used as an illustration of the risks mentioned above.

Although the ECB’s unlimited liquidity provision for the banking sector may have avoided a bank run, it simultaneously created a set of so-calledzombie banks’. Precisely because of the absence of an exit strategy, these banks have now become reliant on ECB liquidity to survive, while stripping them of the incentive to reform the bad practices and mismanagement which got them into this situation in the first place. The cost of this is now becoming clearer, with some banks on the precipice of failure, forcing a widespread recapitalisation of the banking sector – of which some cost will undoubtedly fall onto taxpayers. Against this backdrop, it becomes a huge risk for the ECB to stake its independence and credibility on the hope that such a solution will be achieved in the near term.

Targeting the spread between German bunds and other eurozone bonds would also significantly undermine the ECB’s independence. Ultimately, the spreads are reliant on the fiscal policy and domestic politics of each member state.

Any failure or uncertainty in either area spooks markets. As such, the level of ECB bond buying could become almost directly influenced by the political and policy decisions in member states. The ECB is already treading perilously close to this line. One step further and it would cease being the independent central bank that is so essential to future monetary stability, and instead become a fiscal actor highly susceptible to political wrangling.

This also raises questions over the definition of the bond run. It’s true that the yields may not currently accurately represent the economic fundamentals of each nation, however they are a result of the markets trying to price in the domestic and European political risk as well as the structural flaws in the eurozone exposed by the current crisis. Using the ECB to try to ‘correct’ these issues not only damages the price determination mechanism in markets but takes the ECB far beyond its mandate.

Moreover, the German fears over hyperinflation cannot be seen as an anomaly – it is a political reality that goes to the heart of the German post-world war settlement. The day the ECB is turned into a politicised lender of last resort, may also be the day when the Germans start to seriously question whether they wish to be a part of the single currency.

The struggling eurozone countries need to press ahead with economic and institutional reform. But in the longer term it has now got to the point where the eurozone will have to reassess its structure and membership if it is to survive. Having the ECB act as a full lender of last resort will detract from these requirements and may throw up more problems in the longer term; making it ultimately self-defeating.
The writer is an economist at Open Europe, an independent think tank on the European Union.

Last updated:November 21, 2011 7:32 pm

China property sale falls could hit banks

The number of property transactions in China’s largest cities has fallen to dangerously low levels, according to regulatory documents obtained by the Financial Times.

According to the documents, the China Banking Regulatory Commission earlier this year ordered domestic banks to weigh the impact of a 30 per cent decline in housing transactions in “stress testsaimed at determining the health of the Chinese financial system.

While the government has been trying to rein in sky-high property prices, a Chinese real estate slump would have a significant ripple effect on the global economy. Property construction accounted for more than 13 per cent of China’s economy last year.

In April the CBRC told banks to test their loan books against a 50 per cent fall in prices, and also a 30 per cent fall in transaction volumes.

In October, however, property transactions fell 39 per cent year-on-year in China’s 15 biggest cities, according to government data. Nationwide, transactions dropped 11.6 per cent, accelerating from a 7 per cent fall in September.

The fall-off in transactions has affected developers’ cash flows and, in some cases, their ability to repay bank loans. Rising defaults after a lending surge in 2009 and 2010, much of which ended up in the property sector, were cited by the International Monetary Fund this month as one of the Chinese financial sector’s biggest risks.

The CBRC has not released the results and declined to comment. But one analyst who reviewed the stress-test documents said they did not take into account the impact that fewer transactions and lower property prices would have on bank collateral.

“If developers can’t sell property and local governments can’t sell land, it’s hard to see why banks would be any better at either task under such conditions,” the analyst said.

Chinese regulatory officials admit privately that the tests need to be improved. One senior official said banks were often unaware that loans to big state-owned enterprises had been funnelled to real estate subsidiaries, and acknowledged that the impact on collateral had not been fully taken into account.

The weaknesses in the Chinese scenarios echo earlier problems with stress testing in the European Union, where regulators underestimated the potential impact of a sovereign debt crisis.

The fear is that the impact of a bursting of the Chinese property bubble could yield a crisis just as dramatic as the one now unfolding in Europe. Rising defaults after a lending surge in 2009 and 2010, much of which ended up in the property sector, were flagged by the International Monetary Fund this month as one of the major risks hanging over the Chinese financial sector.

While Beijing’s campaign to cool the property market has had its intended effect, some analysts worry that the government has underestimated the impact its measures are having.

The measures, including higher downpayments and restrictions on home purchases, have taken nearly two years to gain traction.

But the concern is that the government will have trouble shifting gears quickly to respond if necessary. The fall in the number of in buyers is also beginning to weigh on construction, which could deal a blow to the wider economy.

Those knock-on effects were barely tested in the stress analysis. Banks were told to catalogue a series of property-related loans: to developers, for mortgages and to upstream industries like cement and downstream industries like furnishings. But the methodology imagines that while house prices drop, overall economic growth remains more or less unimpaired.

Before property prices drop 30 per cent, one needs to think how much sales are down and, more importantly, how much construction is down. Not only will that impact on steel and cement, but it also would mean a drop in industrial production, investment and jobs,” one analyst told the FT.

Another analyst said the stress tests did not do a good job of grappling with the way a property slump would ripple through the banking system by resulting in falling land sales and prices on the value of bank collateral. Yet the vast majority of collateral in the Chinese banking system is land or property, so a slump could force writedowns across the board.

“This is the key correlation risk. If developers can’t sell property and local governments can’t sell land, it’s hard to see why banks would be any better at either task under such conditions,” the analyst said.

Additional reporting by Jamil Anderlini in Beijing and Brooke Masters in London

Copyright The Financial Times Limited 2011.

November 18, 2011 10:28 pm

In search of a new Metternich for the Pacific century

A doe-eyed prime minister Julia Gillard of Australia this week hosted Barack Obama in the most consequential presidential visit in decades. The two beleaguered liberal leaders staged a 26-hour love-in, the highlight being an agreement to station 2,500 US marines within five years in the Northern Territory, along with increased use of air and naval bases, army training areas and bombing ranges.

The deal marks the first long-term expansion of America’s military presence in the Pacific since the Vietnam war, and a significant deepening of bilateral ties between the US and Australia, two long-time allies. Local commentators spoke proudly of Australia’s new-found importance in the fast-growing Asia-Pacific region. Cooler heads will wonder what comes next.
However the new tripwire defence in Australia is dressed up, it is aimed squarely at China. Mr Obama made that clear during a speech to the parliament in Canberra. With the tide of war” in the Middle East now receding, America’s focus would shift firmly to the Asia Pacific, he said: “Let there be no doubt. In the Asia-Pacific in the 21st century, the United States of America is all-in.”

Historians will look back and ask whether America’s re-engagement in the Pacific in November 2011 marked the moment when tensions with China, the superpower-in-waiting, escalated irreversibly. Throughout the ages, the failure to accommodate rising powers – or rather the failing of rising powers to accommodate the existing state system – has been a source of conflict.

Germany’s search for a place in the sun at the end of the 19th century is one example. Resource-hungry Japan’s quest for a new co-prosperity sphere in the 1930s is another. No less relevant (but studiously ignored Down Under this week) is America’s own emergence as a world power at the turn of the 20th century, which led to ”the splendid little war” with the former colonial power of Spain, both in Cuba and the Philippines.

A century later, China is not so much the elephant in the room, but the elephant in the region. Lately it has become embroiled in numerous territorial disputes with its neighbours. In addition to the historic stand-offs with India and Taiwan, Beijing has bumped up against Japan, the Philippines and Vietnam in the South China Sea, an area of lucrative mineral deposits. As China’s power grows, the risks of conflict in a region where nationalist demons have largely remained dormant are manifest.

Mr Obama’sPax Americana in the Pacific” is intended to reassure the neighbourhood, including former foes such as Vietnam. The deepening of the 60-year-old mutual defence treaty with Australia also forces a potential enemy to think twice before challenging the status quo. Crucially, however, it does not extend US sovereignty to Australian territory in the manner of the Guam and Okinawa military bases.

The other strand in US/China foreign policy is economic. This weekend’s east Asia summit in Bali will see Mr Obama seeking to solidify trade ties, starting with the Trans-Pacific Partnership (TPP), a group of Asian-Pacific countries, which specifically excludes China. Now, it is possible that the grouping could grow and China might be encouraged to join. But that is not the way it looks now.

“It’s a posse to get China”, writes Peter Hartcher, respected international editor of the Sydney Morning Herald.

The TPP overture comes on top of persistent US criticism of China’s artificially low exchange rate. In the upcoming election year, the temperature can only rise. Yet the White House decision to escalate economic and trade tensions with China when markets remain spooked by the European sovereign debt crisis may not be so smart. Those with longer memories recall how the Reagan administration’s spat with Germany over monetary policy triggered the Black Monday stock market crash in October 1987.

So far, China’s response to Mr Obama’s double power-play has been muted. With a leadership transition due in 2012, Beijing has its own domestic preoccupations. But the Communist party hierarchy is also struggling to manage the economy’s convulsive shift from an investment-led, low-cost manufacturing champion to a more consumer-friendly economy. That shift will be felt well beyond China’s borders. Propelled by waning competitiveness, China’s manufacturers are scouring the world searching for markets, acquiring companies, upgrading technology and building brands.

China Inc’s outward reach is already altering trade patterns profoundly. The key destinations are already coming into focus: Australia, Brazil, Indonesia, Vietnam, Mexico, South Africa and even the US. What distinguishes China’s internationalisation from, say, that of Japan is the speed and scale of the change. In the case of Brazil, Chinese trade was just 2 per cent a decade ago but now accounts for 16 per cent, overtaking the US.

These shifts seemingly spell a decisive shift east in economic power. By 2030, China’s gross domestic product is set to be one quarter higher than America’s. It may have twice America’s share of world trade. Yet China’s GDP per head, at purchasing power parity, is still about a fifth that of the US. It is to become an economic superpower, while still a developing country – a premature superpower, as it were.

Here we come to the risks of mutual miscalculation. As long as the US-Australia military agreement is not the first building block in a rigid containment strategy, China need not feel threatened. As former Australian prime minister Paul Keating says, what is needed is a flexible accommodation of China, through a concert of powers. For that to work in the “Pacific centuryone should turn not to a Chinese theoretician nor to an American idealist, but to the ultimate realist: Prince Klemens von Metternich.

The writer is the editor of the Financial Times and the article is based on this year’s Lowy lecture in Sydney

Copyright The Financial Times Limited 2011.

The Goldman Rule: Don't Let This Puppet Master Pull Your Strings
November 21, 2011
By Shah Gilani, Capital Waves Strategist, Money Morning

Goldman Sachs Group Inc. (NYSE: GS) Chief Executive Officer Lloyd Blankfein was really on a roll speaking at an investment conference in New York last week.


Among other things, he said there's no way we can conclude that a slowdown in banking and trading businesses is "secular, rather than cyclical."

That alone was enough to make me laugh. But then he went on to address concerns about pending regulations that are coming as a result of the Dodd-Frank Financial Reform Act.

."In our conversations with clients, they have expressed several concerns on the impact to their businesses," Blankfein said, making it clear that his firm will make client interests a theme of its arguments against the regulations. "What Goldman Sachs does for our clients is even more relevant and important."

.Now that should make you laugh - if, of course, you're not too afraid.

.The truth is that Goldman Sachs and the rest of the big banks on Wall Street - in the inimitable words of author Michael Lewis from his seminal book Liar's Poker - invariably "blow up" customers to make money for themselves.

Not only do they run roughshod over their customers (trading partners) and clients (banking relationships), the big banks manipulate markets, industries, economies and countries to fatten their already gigantic bonus pools and personal fortunes.

Now, I'm not singling out Goldman Sachs because it's the biggest and baddest bully on the block, which it is. I'm not blasting Goldman because I once idolized the firm - its culture, its talent, its sheer money-making prowess - and have seen its vision blinded by greed since going public in 1999. I'm not saying Goldman is the only self-serving, greedy, and pretentious firm on Wall Street. And, I'm certainly not calling out Lloyd Blankfein, whose extraordinary accomplishments as a trader are legendary, but whose leadership of Goldman has been marred by what might generously be described as "PR gaffes."

What I am doing is using Goldman as proof positive that Wall Street banks are bad news.

In fact, rather than seeing them rebound we would all be better off seeing them unwound.

From Wall Street to K Street - And Back
Let me start with the nexus of power and money in this country. That nexus resides exactly where Wall Street and Washington intersect. Each serves the other and the middle-class be damned.

You see, the "revolving door" metaphor that's so often used to describe the relationship between Wall Street and Washington isn't exactly accurate.

The reality is that there is no revolving door. There are no doors at all. It is more like one giant corridor where all the water cooler talk is about paying for campaigns, paying lobbyists, and paying bonuses.

There's a reason why Goldman Sachs is derisively referred to as "Government Sachs." The flow of executives and operatives between Goldman and Washington, and even other world governments and central banks for that matter, is legendary.

I can't point out all the connections - there are simply too many. But I will point out a few that you may not be aware of.

How about Robert Rubin - the former Goldman co-CEO who became Treasury Secretary in the Clinton administration? From that post, Rubin squashed all regulations pertaining to derivatives, and ended Depression-era laws like the Glass-Steagall Act (which separated commercial banks from investment banks) so giant Citicorp could be formed by the merger of Travelers and Citibank. Rubin then went to Citigroup Inc. (NYSE: C), where he made some $119 million while leveraging the bank up with derivatives before it had to be bailed out.

.Bailed out by whom? Bailed out by then Treasury Secretary Henry M. "Hank" Paulson, himself a former Goldman CEO.

.And bailed out how? With the help of the Federal Reserve Bank of New York, whose chairman was Steve Friedman, a former Goldman partner, still on Goldman's board.

.That's the same Steve Friedman who bought $3 million worth of Goldman shares based on allegedly inside information he garnered at the Fed and from Goldman's board meetings, profited handsomely, and had to resign from the Fed board -- but not give any of his profits back.

.And finally, Goldman itself had to be bailed out when it ran to the Fed on a Sunday in September 2008 to beg to be turned from an investment bank to a bank holding company so it could get Fed cash.

.The Usual Suspects
There are innumerable connections and fascinating stories. So, I won't bore you with the one about Goldman arranging a currency swap at an apparently "fictitious" exchange rate for the government of Greece. Nor how that swap facilitated Greece hiding its debts to get into the Eurozone, so it could then borrow euros ad nauseam until it had to be bailed out - again and again.

I'm not going there. Because if I did I'd have to get into how precariously positioned the new "technocrats" -- who are supposed to save Italy with the help of the ECB -- actually are.

And who are they?

Well, there's Mario Draghi, the new president of the ECB. Super Mario, it turns out, was Vice Chairman and Managing Director of Goldman Sachs International, and a member of the firm-wide management committee from 2002 to 2005. He claims to have not been responsible for the Greek currency swap, saying it was arranged before he went to Goldman. But he's never denied it.

That's comforting.

If he runs the ECB the same way Goldman runs its business, there might be some areas where transparency may not be the order of the day. And isn't that exactly what a central bank is supposed to be about?

If I had more time here I'd mention that Mario Monti, prime minister-designate of Italy, not only was a European Commissioner, but an international adviser to Goldman Sachs.

I'm just comforted to know that these old buddies are all still manipulating global finances for the betterment of our interests and the Goldman bonus pool this fiscal year or next.
Customer Service
I'm also not going to get into how Goldman set American International Group Inc. (NYSE: AIG) up to fail, or how the New York Fed made the firm whole on the credit default swaps it had written on AIG. Nor will I get into how Goldman board member Rajat Gupta allegedly passed along boardroom secrets to his friend and Goldman customer Raj Rajaratnam (now serving time for insider trading), or how the Justice Department is looking into how Goldman teed-up millions of investors and hit a hole in one when the mortgage market failed and they were short.

I'm only going to point to one small incident that proves Goldman really does have the interest of its clients at heart.

Back in 2007 Goldman constructed a little billion-dollar deal for a customer named John Paulson. Only the firm didn't tell its other customers, the ones to which it sold the Paulson deal known as Abacus 2007-AC1, that the deal was designed to fail.

Paulson made out like a bandit because he bet against the deal. Now that's good customer service.

Goldman didn't admit any wrongdoing and paid a paltry $550 million fine, which in terms of its 2009 earnings amounted to 15 days worth of register ringing.

So, let me get this right: Goldman, and the rest of its big bank brethren, are all about their customers. And they want their customers to go to bat for them with the regulators.

I suppose it was those nasty regulators that caused the whole credit crisis and the Great Recession in the first place.

And I guess that means that if Goldman, with the help of its customers, can get all those pesky regulators out of the way, we'd all finally be free to do business and live happily ever after - especially Goldman and the rest of big banks, of course.