If one considers the euro area debt crisis properly, it should be clear that it is not – at least not yet – a currency crisis. It is a sovereign debt crisis combined with a bank solvency crisis that has the potential to become a currency crisis.
There are two ways in which it can transmogrify into a currency crisis. Firstly, it could become one if the euro area were to fall apart, by which we don't mean a mere splitting off of say Greece and/or Portugal. Such a splitting off of weak peripheral economies would strengthen rather than weaken the currency area. However, if for instance France or Germany were to decide to leave the euro (both 'unthinkable' only a few months ago, but no longer) and return to their national currencies, then the very existence of the euro would become doubtful. Secondly, it could become a currency crisis if the ECB gives in to all the pressure heaped on it and decides to embark on a massive money printing spree to 'save' the overextended fiscal offenders.
Speculators have recently put on a massive record net short position in euro futures:
Commitments of traders in euro futures: speculators have put on a record net short position – click for higher resolution.
However, this position is not really sensible at the moment. Here is why: euro area money supply growth has been the lowest in the whole world over the past year, with the true money supply growing at a mere 1.3% year-on-year. This compares with over 15% true money supply growth in the US and 5% in Japan. Why should the euro fall when fewer euros get printed than other currencies? Note that this is not to say that it cannot fall. In the short to medium term currency exchange rates are often driven by other considerations than relative money supply growth. However, the euro even enjoys a slight interest rate advantage over dollar, yen and the pound – one that admittedly is set to shrink in coming months.
There is another reason however why this bet may turn out to be tactically wrong. The ECB and Germany remain firmly committed to their 'no money printing to bail out the PIIGS' stance. In fact, as John Hussman points out this week, there is very little ambiguity in the ECB's statutes. For instance:
“The Treaty is very specific in restricting the ECB from assisting individual governments. Article 123 of the Treaty on the Functioning of the European Union prohibits the ECB from providing any type of credit facility to central governments (and specifically "any financing of the public sector's obligations vis-a-vis third parties"). That Article also effectively means that the ECB is prohibited from providing funds to "leverage" the European Financial Stability Facility (EFSF).”
There is a lot of pressure on the ECB to alter its stance and we can of course imagine that ways could be found to circumvent these legal obstacles. The EFSF itself has after all been established on the flimsiest legal pretext imaginable – the EU based it on a paragraph of the Lisbon treaty that is normally reserved for giving mutual assistance to countries hit by a natural catastrophe, such as an earthquake. This was done to skirt the 'no transfer union' clause.
Note however that apart from the legal situation and apart from the genuine convictions of the personae dramatis, both Germany and the ECB would stand to lose quite a bit of face by now if they were to relent and give up their determination to find a solution that does not depend on monetary largesse.
Assuming that they will continue to stand firm, what else must someone short the euro keep in mind here?
One important factor is the situation of the euro area banking system. Given that the banks need to increase their core tier one capital ratios sharply, they have begun to sell assets and shrink their balance sheets. National regulators are also contributing to this drive to reduce assets held by commercial banks. As an example, here is a recent directive from the central bank of Austria:
“Following intensive consultations, the Austrian Financial Market Authority (FMA) and the Oesterreichische Nationalbank (OeNB) have devised a set of measures to make the business models used by Austrian banks operating in Central, Eastern and Southeastern Europe (CESEE) more sustainable. These measures will be published as prudential guidelines before the end of 2011.
The package of sustainability-boosting measures is meant to strengthen banking groups’ capital adequacy and to improve CESEE subsidiary banks’ refinancing options as follows:
First, to bolster banking groups’ capital bases, the Basel III rules will be implemented fully as soon as they take effect on January 1, 2013 (the participation capital subscribed under the bank support package will be included in the capital base). Second, as from January 1, 2016, banks will be obligated to hold an additional common equity tier 1 ratio of up to 3%, depending on the risk inherent in the respective business model.
To promote the subsidiaries’ refinancing structure, credit growth will in the future be conditional on the growth of sustainable local refinancing (comprising mainly local deposits, but also local issuance activity and supranational funding, e.g. by the EBRD or the EIB). In the future, subsidiaries that are particularly exposed must ensure that the ratio of new loans to local refinancing (i.e. the loan-to-deposit ratio including local refinancing) does not exceed 110%”
All of this means that bank lending both in the euro area and the neighboring CEE nations will be reduced henceforth. In addition, there is ongoing deposit flight. In all the 'PIIGS' the true money supply is currently deflating, in some cases at quite astonishing speed as depositors, fearful of the state of the banking system and fearing the possibility that their nation may leave the euro and slap on capital controls, are withdrawing their money. Thus we now see the 'reverse multiplier effect' in action in the PIIGS. Readers should consider our description of the money multiplier effect in part two of our article series on fractional reserve banking (see: 'The Problem of Fractional Reserve Banking, part 2'). It makes a very big difference to the money supply whether money is held in the form of money substitutes, i.e., deposit money inside the banking system, or in the form of currency outside of it.
Lastly, as euro area banks sell off assets denominated in foreign currencies, they repatriate capital, which puts a certain degree of upward pressure on the euro as well. Similarly, their drive to cut down the size of the assets they hold means that they are reluctant to extend new credit. Should the paying back of outstanding credit exceed the extension of new loans, the euro money supply is bound to decrease.
All in all this means that the speculators currently shorting the euro are in effect not betting on what is happening, but on what might happen. The fact that such a large majority of speculators has already sold the euro means that the scope for additional selling is fairly small. If you consider the chart above, it is clear that once the net speculative short position reaches such extreme levels, the market is close to a trend reversal, at least in terms of time. This does not preclude a marked price decline in the time that is left until the reversal happens, but one should be aware that time is growing short.
As an aside to the above, retiring Deutsche Bank CEO Josef Ackermann confirmed once again that Germany's banking establishment actually backs Jens Weidmann's hard line:
“He [Ackermann, ed.] also said on Monday he was against the European Central Bank acting as the lender of last resort to fiscally ailing governments, which would allow it to buy an unlimited amount of sovereign debt, adding he now opposed mutually-backed euro bonds.”
Source: Acting Man
