When investors think of risk from Europe’s sovereign debt crisis, they think of the periphery: Greece, Spain, Ireland, Portugal, perhaps Italy.
What they should be thinking of is Germany and its troubled banking sector, says Josh Rosner, managing director of New York-based consultancy Graham Fisher & Co., and author of Reckless Endangerment: How Outsized Ambition, Greed and Corruption Led to Economic Armageddon, a New York Times bestseller.
He says Asian investors should consider German bunds as highly risky and, if they require a European fixed-income exposure, consider diversifying into high-quality corporate bonds instead.
“This is as much about profligate lending as it is profligate borrowing,” says Rosner.
Asia has not been immune to Europe’s weakness, as this region’s exporters find the eurozone’s austerity policies hobbling consumers. Rosner says Asia-based officials, policymakers and bankers should exhort their European counterparts to recapitalise banks and support quantitative easing by the European Central Bank.
“The fear of inflation at the Bundesbank has led the ECB to pursue an overly tight monetary policy, which is only exacerbating the banking problems at Europe’s core, and worsening conditions for Asian trading partners,” Rosner says.
By several metrics, he finds German banks to be in a deep structural malaise. In terms of non-performing loans, provisioning, leverage and returns on assets, German banks often rank below peers in Italy, Spain and many other members of the European Union.
Although there are universal expectations that banks in Europe’s troubled periphery must be recapitalised, Rosner argues the need is just as acute in Germany and France, but that efforts to do so have been half-hearted.
In response, global market investors are retreating from providing short-term funding to German and French banks, leaving these institutions ever more reliant upon the ECB, the Bundesbank and the US Federal Reserve’s unlimited swap lines.
The seeds of this crisis were sewn in the run-up to European monetary union, but the real problem wasn’t the number-fudging and lack of preparation in countries such as Greece.
The real problem was that EMU occurred in the aftermath of Germany’s reunification, a painful process that left the enlarged sovereign government with a weak balance sheet and high unemployment.
Germany entered EMU with an overvalued currency and it addressed its fiscal problems by cutting wages rather than boosting productivity. That has robbed German consumers of a decade’s worth of wealth and drove German industry – and their lenders – to focus on exports, not domestic demand.
The banks, finding fewer domestic lending opportunities, diversified their asset base, by massively lending to periphery banks, companies and governments, and by investing in things like US sub-prime debt. These losses have not been realised in full, but the threat of losses is forcing European banks to now cut back on lending, including to Asia.
Although German politicians insist on austerity in the European periphery, this is turning out to be a self-defeating move. Some 60% of German industry exports over the past decade have been to other eurozone countries; austerity forces European consumers to cut back on German goods.
Austerity is also damaging German and French banks, which by mid-2010 together held 61% of the $1.6 trillion (or $976 billion) in total outstanding debt issued by Greece, Portugal, Spain and Ireland. Only $174 billion of that debt was sovereign; the great majority of Franco-German lending has been to periphery corporations and individuals. This is why Rosner argues that Europe’s problem isn’t Greek sovereign debt, so much as it is the embedded hazards in core European banks.
This also explains why, despite the political statements to the opposite and in the face of opposition from the Bundesbank, German chancellor Angela Merkel has gradually agreed to a variety of short-term bailouts to the periphery, such as the ECB’s three-year Long Term Refinancing Operations.
“The supposed bailout of the periphery is really a bailout of German banks and companies,” Rosner says. “Once the market figures this out, it will pressure Germany to realise its bank losses. Or a Greek exit from the eurozone will force German banks to realise those positions.”
But what if Europe preserves the euro and enacts deeper fiscal, financial and regulatory integration? “Then the ultimate costs of that are borne by the core nations, particularly Germany,” Rosner says. “Existing holdings of ‘safe haven’ Bunds are at risk of investors demanding far higher yields, as they realise that regardless of the outcome of the eurozone crisis, it is the banks within the core that are exposed. Germany is not a safe haven.”
He says the only way out for investors is to lobby Germans to support ECB slashing rates and embracing inflation as a means of escape – an outcome vociferously opposed by the Bundesbank and many German citizens, who remember Germany’s hyperinflation during the Weimar Republic and the subsequent turmoil that brought the Nazis to power.
In the meantime, Asian investors should diversify Bund positions into new or more stable assets, including sovereign bonds from Singapore, Canada, Australia, the US and Demark; or adding high-quality corporate bonds from within Europe.
Aside from the US Treasury market (itself suffering from poor fundamentals, although fortunate to have a healthier banking system), these assets lack the liquidity required of most investors, such as central banks. But, Rosner argues, at least some diversification can soften the inevitable blow when Bund prices start to fall.