BEHIND THE SCENES, by François Leclerc

Guest post. Translated from the French by Tim Gupwell

There are some sinister goings-on behind the scenes of the European financial system, which are hardly being proclaimed from the rooftops! Even Mario Draghi himself is preoccupied by it, drawing attention to vague manifestations of “fragmentation” which are developing at the heart of the Eurozone. What was he alluding to?

It is occurring in three stages: an ongoing capital flight from countries on the verge of the abyss, leading to their banks becoming increasingly dependent on ECB loans, with the liquidities then supplied by the latter being used to buy state-issued debt, in order, for the time being, to prop up the whole edifice.

The way to put an end to this ultimately destabilizing process would be to renew confidence in the continuity of the Eurozone. This explains the plan to put together a fiscal union, then a banking one, and finally a political union. But all this takes time, and there is precious little of that available. All the more so as the regulators themselves are pushing for a reduction in these financial establishments’ cross-border exposures so as to reduce systemic risk, thus accentuating a process that people are trying to stop elsewhere ….

The result of all this is an increase in the ECB’s exposure to Spanish, Italian and Portuguese banks. In July, banks from these countries had borrowed 60% of the sum total of central bank loans. The Greek and Irish are a case apart since their banks, no longer able to tap the ECB due to lack of collateral, are both now financed by their national central banks, under the framework of the Emergency Liquidity Assistance (ELA). This puts the risk back on to the ECB’s shareholders, the states – which are already in a bad way.

The Eurosystem is certainly financially strong, but another factor has just been added into the mix. As the capital departing from the Southern countries is gradually repatriated in its country of origin, the Bundesbank is seeing its claims increasing at the heart of the Target 2 system which manages the relations between the National Central banks of the Eurozone. Its liabilities now exceed 700 billion Euros, an amount which is likely to keep on increasing. The dependence of the banks on the ECB is likely to do likewise.

Finally, a third phenomenon has occurred at the same time. The Northern European banks which continue to finance themselves on the markets, particularly from money market funds are finding that this market is less receptive to their requests. As a consequence the volume of these operations is diminishing, expressing in certain cases the particular financing difficulties of lending establishments.

With these mechanisms continuing to produce their effects, the ECB is attending to the most urgent matters first. It has no other solution to prevent serious slip-ups than to intervene once again on the sovereign bond debt market. With the fate of Spain having been already decided on in reality, even if its rescue package is not yet official; it is the next one, Italy’s, which is at stake.

It is this which explains the idea recently floated, in which the ECB would intervene as soon as the spread for a country’s debt – Italy’s for example – exceeds a certain value, in the framework of a global accord for deficit reduction. In fact this is exactly what Mario Monti has kept asking for, so far without much luck. This is because the German government continues to oppose the pursuit of the ECB secondary market bond acquisition programme. Wolfgang Schäuble has justified the reasoning behind this by explaining that “if we set out on this path, we will never stop. It’s like when you try to solve your problems with drugs”. The German Government would be more credible however if it was not obstructing the direct supervision of saving and mutual banks by the ECB, and if it was not opposed to contra-cyclical measures. One impasse for another….

Condemned to having to get on with each other, Angela Merkel and François Hollande are once again going to have to seek a compromise, which will do nothing more than delay the problems for a little longer. This compromise will need to incorporate the fate of Greece, something dictated by the leap into the unknown that a Greek Eurozone exit continues to represent – in spite of all the precautions taken. To do otherwise would also be tantamount to admitting that two successive rescue plans have not been able to prevent this, in circumstances where it would be difficult to put the exclusive blame on the succeeding Greek Governments. A Greek exit from the Eurozone would sound the death knoll of the debt reduction strategy which has been advocated. Something very difficult to admit to…