Ad Hoc Commentary – ECB rate cut: the European sovereign debt crisis has come home to roost

The official story is the European Central Bank (ECB) interest rate cut is to prevent euro zone’s recovery from stalling as inflation tumbles. That is good enough for most. However, yours truly believe this move signals the return of the sovereign debt crisis to Europe. In Aug 2012, we said the European debt crisis had ‘solved’ itself and is going for Japan. Today, we say the crisis returns to Europe as a banking & sovereign crisis.

There is no political capital left for bail-outs and the European Stability Mechanism (ESM) do not have enough firepower. It is not even clear if super Mario Draghi can throw another trillion dollars of LTRO money into the banks since it is likely that first trillion will need to be rolled over when it comes due. So, as outrageous as it might sound, we are closer to a Cyprus-style bail-in in Europe. In Cyprus, the bail-in levy was 0% for the first EUR100k and 47.5% thereafter. What should the haircut be for Europe as a whole to support the banks and sovereigns? You can find it on Page 49 in Box 6 of IMF’s recent Fiscal Monitor at
“…The tax rates needed to bring down public debt to precrisis levels, moreover, are sizable: reducing debt ratios to end-2007 levels would require (for a sample of 15 euro area countries) a tax rate of about 10 percent on households with positive net wealth…”

If the 10% bail-in levy is not followed by real reforms, then it will lead to either massive financial repression as in Cyprus via capital controls; or in the absence of capital controls, massive capital flight from Europe.

The problem in Europe is the creation of a pan-European currency, without the creation of a pan-European asset class. The absence of such an asset class forced banks to hold sovereign debts of individual countries as reserves. Cyprus was the first victim of the banking reserves crisis – the Greek bonds on their bank’s balance sheet brought their financial system down. It is probably necessary to use a 10% tax to create a sustainable permanent bail-out fund. However, long-term sustainability depends on reforms of banking reserves. If Germany will never agree to debt mutualization to create a pan-European sovereign bond, then they need to find alternatives.

The only alternative seems to be a pan-European infrastructure bond. Yours truly had briefly mentioned about it in our last note on saving the world monetary system:
“…A similar bond can be launched in Europe and the securitized infrastructure bonds can then be used as banking reserves to prevent further Cyprus-like mishaps. This could be the next best thing to the Eurobonds that Germany would never agree to. Once we have all these in place, we will end up in a world with less strained sovereign balance sheets…”

Infrastructure finance, in particular infrastructure equity funds, had got a bad name after the crisis of 2007. The low historical correlation with bonds (0.38) and listed equity (0.21) turned out to be a very bad predictor of the future. The numbers are from the Peng and Newell 2007 study: The Significance of Infrastructure in Investment Portfolios, Pacific RIM Real Estate Society Conference, Freemantle, 21-24 Jan 2007. In the crisis of 2007, infrastructure equity funds that were sold as low risk and with the benefit of improving the efficient frontier (i.e. left and up), turned out to be a fallacy. In the panic, it was correlated just like everything else.

Despite all the excitement surrounding infrastructure equity funds, the future belongs to infrastructure bonds. Infrastructure bonds do not have a bad name and can be structured as long-duration, and possibly inflation-linked investment instruments. Insurance and pension funds who are dying for 8% type of returns (these guys are in hot soup) are probably going to find infrastructure bonds the next best thing after sovereign debt. It would be easier to justify moving out of sovereign bonds into infrastructure bonds than into equity linked structures.

Unfortunately, even though infrastructure needs are massive, the current infrastructure market is too small to accommodate more than a mere fraction of the 90 trillion or so in currently in sovereign bonds. Given the urgency of having a place to park money, success in this space will have to involve existing infrastructure as opposed to finding new shovel ready projects (i.e. brownfield projects as opposed to greenfield projects). This reminds us of the privatization models of the past – there is some truth in the maxim ‘privatization of profits, and nationalization of losses’. However, as long as those structuring the future are mindful of the past lessons of selling the family silver, we will have a workable solution ahead. The last thing we need is more austerity in terms of taxes.

In any case, the sovereign debt crisis had returned to Europe as a banking & sovereign crisis. It never really left it actually. The ECB just brought awareness to it by cutting rates without a very credible public explanation.

Good luck in the markets.