STAFF NEWS & ANALYSIS
ECB Warning on Banks Rattles Global Markets
By - June 16, 2009

The European Central Bank has given its starkest warning to date on growing strains in the eurozone credit markets. It said it is expecting fresh bank writedowns to hit $283bn (£173bn) by the end of next year. "Policy-makers and market participants will have to be especially alert in the period ahead. The credit cycle has not yet reached a trough," said the ECB's Financial Stability Report. "The deterioration in the macro-financial environment has continued to test the shock-absorption capacity of the euro-area financial system. Prospects for a significant turnaround in the short term are not promising," it said. – UK Telegraph

Dominant Social Theme: Worse to come.

Free-Market Analysis: Yesterday we wrote of the G8's optimism in plotting ways of restraining resurgent economies and potential inflation. Today, perhaps, they might wish to slow down the parade. The Dow dropped almost 200 points yesterday, and as we write our modest paper, Asian markets are "extending" American and European losses.

Of course, Europe is not America, and perhaps America is better positioned to weather the storm than Europe. But somehow we doubt it. Both the International Monetary Fund and the European Central Bank are giving off squawks of dismay about the unfolding crisis, especially when it comes to Western Europe's exposure to Eastern Europe. Absent a recovery, those loans will weigh heavily on Europe's biggest banks and hitherto strongest economies.

The ECB has slashed its forecasts, predicting a 4.6% contraction this year and a further fall of 0.3% next year, with no recovery until mid-2010. This precludes any chance of a V-shaped rebound. The clear implication is that the ECB is battening down the hatches for another storm as rising defaults eat into bank capital. This aligns the ECB with the International Monetary Fund, which has called for urgent action by EU authorities to clean up Europe's banks and disclose likely damage. Piroska Nagy, an adviser to the European Bank for Reconstruction and Development, said the danger is that West European banks will retreat from Eastern Europe, "causing a collapse of the banking sector" across the region.

Obviously, a V-shaped recovery is in everybody's interest – everybody who works for a commercial bank or a central bank, that is. We don't. At this point, we would probably be just as comfortable with a quick collapse as a slow one. A slow one offers retrenchment opportunities, while a quick shocking one might involve a sharp break from business as usual. Enough shocks to the system and maybe something else will take its place. Maybe the current Masters of the Universe will panic so badly that they will finally allow a normal money system to take root.

Of course a lot of the rhetoric still consists of happy talk. There is apparently the idea that one can jawbone the economy back up. American bankers and leaders speak of a quick end to the "recession," even as their European counterparts wallow in increasing gloom. This begins to resemble the era of the Great Depression where statements about a coming recovery conflicted with grim news the next day that placed the economic scene in a starker light. And stark it is from a European point of view, no matter the G8's focus on recovery.

There is no quick fix for Eastern Europe. "It is going to be even more difficult for them to export their way out of trouble than it was for East Asia in the 1998 crisis," said Edward Parker, Fitch's head of emerging Europe. This time the whole world is in recession. Besides, Latvia, Estonian, Lithuania and Bulgaria are trapped with currency pegs at over-valued rates, implying harsh deflation. "There is a limit as to how much pain can be borne in democracies," he said. Russia's central bank rattled the global bond markets by warning that it planned to cut the share of US Treasuries in its foreign reserves. The news caused the yield on benchmark 10-year bonds to spike to almost 4%, a level that risks crimping mortgage finance and short-circuiting recovery. Russia's reserves have fallen by almost a third since the peak of the oil boom last year but it still boasts $404bn, the world's third largest reserves. Roughly 30% is held in US Treasuries.

Just yesterday we wrote we found a V-shaped recovery hard to credit, and today once more the IMF and the ECB seem to agree. Here is the tough truth as related by the article excerpted above: "Western European banks have $1.6trillion (£977bn) of exposure to the region, led by Austrian, Belgian, Swedish and Dutch lenders. While attention has been focused on Latvia's currency peg, large losses are building up in Hungary, the Balkans, Russia and Turkey."

Despite the negatives emerging again today, we do feel that price inflation will at some point rise up, and in a big way. The trick is the timing. And we continue to believe that there could be several more serious credit crises before Western economies enter into a phase of credit expansion, and resultant price inflation. Potentially, the current paper money system could suffer from fatal injuries either during the credit contraction phase or the following inflationary phase.

After Thoughts

What can be said most accurately about the current leg of the business cycle is that it will continue to be extraordinarily volatile given the amount of damage that has already been done. There will be a war of words between bankers, regulators and the mainstream press as to how to go about presenting the actuality of this economic peril. Despite G8 happy talk, the reality is apt to be brutal. Given an L-shaped recovery, we think we could be looking at a precious metals based standard of some sort before this "greater depression" has run its course.

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