2014-02-17 By Harald Malmgren
ECB President Draghi’s promise to do “whatever it takes” to defend the Euro is simply not meaningful without German support.
When Draghi brought forward his Ordinary Monetary Transactions (OMT) concept as available under the mandate of the ECB to maintain monetary stability, the Bundesbank promptly sent the OMT to the Karlsruhe German Constitutional Court for review. After unexpectedly long deliberations, the Court ruled 8 to 2 that OMT was illegal under German law as it was inconsistent with EU treaties’ prohibition of financial transfers among EU member governments.
For many months last year German Finance Minister Schauble publicly declared that a rewrite of EU treaties, or at least of the treaty establishing the Euro and the ECB, would likely be necessary. His ministry has been at work for months preparing hypothetical drafts of a treaty revision, so it is not likely that he and his colleagues, or Chancellor Merkel, were surprised by the negative determination of the Karlsruhe Court.
The German Court opinion did refer its determination for further review by the European Court of Justice. Press and media initially interpreted this as a yielding of authority to an intra-European judicial body which normally supports decisions reached by the European Commission and its various supporting ministerial committees.
The German Court Ruling and Its Impact
However, a closer review of the German Court finding is that an extra-German legal opinion would not alter the illegality of OMT under German law.
Another way of interpreting this position is that if OMT were to be permitted by other EU or EZ governments, Germany would nonetheless not be legally able to participate.
Without Germany’s backing, OMT looks like a card player’s bluff, with a hand that could not win.
Der Spiegel reported that the court ruling amounts to a full-blown showdown between Germany and the European Central Bank over the methods to shore up southern Europe’s debt markets:
“It is nothing less than a final reckoning with the crisis-management strategy pursued by the ECB. The German justices insist that the German constitution sets limits on the ECB’s crisis strategy. In a worst-case scenario, the Court could forbid Berlin from contributing to efforts to save the euro or even force Germany to leave the currency zone entirely.”
Germany’s top financial and economic institutes questioned whether quantitative easing is now possible, leaving it unclear how the ECB could respond to possible deflation or any form of further bond buying…..
Hedging for A Euro Exit?
In the background, Eurozone bank lending continues contracting, as EZ banks shrink assets in a vigorous effort to improve their capital/asset ratios. This has been difficult in the face of market reluctance to supply new capital to non-transparent EZ banks with likely growing non-performing loans (NPL’s) during an extended period of economic contraction or stagnation driven by fiscal austerity.
Euro optimists point to the narrowing of sovereign debt yield spreads among EZ member governments, but this was based on market expectations that the ECB would “do whatever it takes” to prevent a financial market collapse.
Yield spreads were also narrowed by active purchasing of sovereign debt by banks residing in troubled economies. According to internationally agreed guidelines, banks are permitted to treat sovereign debt of their own countries as Tier 1 capital.
Acquisition of large amounts of one’s own sovereign debt also leaves open a safety net in the event of exit from the Euro, as the debt would remain denominated in domestic valuations.
With banks motivated to buy their own sovereign debt, other investors saw opportunity in acquiring high-yield EZ sovereign debt in anticipation of declining yields and rising capital gains opportunity.
Pursuit of a New Banking Union
In the meantime, progress in EZ pursuit of a banking union has been impeded by a multiplicity of national objections or conditions that will take time to resolve.
EZ officials had been racing to try to reach agreement in time to submit the agreement to the European Parliament before spring elections of a new Parliament. If an agreement could be submitted to the present Parliament it would likely be approved.
However, if a bank union accord had to be submitted to a new Parliament, there is fear that the newly elected Parliament would likely have a significant increase in Euroskeptic members who would block early action and might even succeed in rejecting a bank union along the lines preferred by present financial officials.
With Germany posing many of the most serious impediments to agreement, it is likely that bank union will have to be sent to the new Parliament, which would most likely take more than another year to weigh its pros and cons. ….
Additional Challenges: A Transatlantic Rift and Chinese Bank Exposure
The US Government intends to accelerate and amplify Basel III capital requirements not only on US banks but on foreign (European) operating in the US market.
Initially, in this quest, US authorities planned to apply heightened capital requirements against gross value of derivatives contracts held by major banks, but push back by European governments and some US banks resulted in adoption of a much smaller capital hit measured against “net” derivatives.
Even so, EU banks fear yet another round of demands for additional capital from the US, with stricter definitions of what derivatives contracts might be encompassed by new US rules.
Underlying a Transatlantic rift is an unexpressed but continuing determination of US regulators to shrink leverage in all forms of banking, and ultimately to shrink the size of systemically important financial institutions (SIFI’s). Europeans, especially the Germans and French, do not wish to disturb the large role of their biggest banks in present German and French financial markets.
A temporary compromise was recently reached between US and EU regulators on trading in derivatives and futures. Nonetheless, frequent complaints can be heard in Washington about the lack of cooperation between US financial market regulators and EU/EZ regulators.
One positive development for Europe was a recent decision by the Federal Reserve to “make permanent” and in some cases enlarge its currency swap arrangements with the UK and the ECB (as well as with other nations).
It seems that the Federal Reserve may have been anticipating some strains on financial markets, especially on short-term funding, that might result from its “tapering” of purchases of Treasuries and mortgage backed securities.
(Some question has been raised by academic lawyers in the US as to whether the Federal Reserve has legal authority to extend permanent swap lines, but that issue remains to be reviewed at a later date.)
It remains true that European banks are still overly dependent on short-term funding, at a time when financial market volatility is likely to increase, and when US authorities are eager to increase constraints on repo agreements, including on required “haircuts” against collateral, in a determination to squeeze leverage derived from cheap short-term funding.
Yet another challenge to EZ banks is gradually developing in EZ bank exposure (primarily German, French and UK banks) to Chinese shadow banking, asset backed securities, and commodity derivatives contracts at a level about 4 times larger than the total exposure of US banks….
The continuing Euro crisis is playing an important role in sidelining Europe from dealing with the twin crises in the Ukraine and the Middle East. The crisis as well has been part of the Russian return to the global stage, and providing Putin with a greater sense of confidence that he can handle Europe on the world stage.
In other words, the Euro crisis is a significant challenge all by itself but is also a key element in limiting Europe’s role in the world and the perceptions by others, the Russians, Chinese and Iranians that Europe has little maneuver room to deal with other issues globally.