Greece: the mouse that roared
In the first of a two-part special on the future of the eurozone, Robert Kyprianou examines whether a run on banks could be around the corner.
Last week I visited Athens to see first hand what impact the shock election results might have on the Greek tragedy that has unfolded over the past two years, and whether the subsequent market fears are valid or represent an opportunity for investors.
Although there was a lot of noise and myths in the air, I came back clearer in my thinking about the real issues at the core of the euro crisis.
The only tangible thing to emerge from the otherwise fragmented electoral outcome in Greece was to give a voice to the anti-bailout protagonists. This, and Hollande’s victory in France, has thrown the spotlight on the debate over whether fiscal austerity or targeted spending is the right tool to restore growth and reduce deficits. The markets have come to fear that the euro may be a casualty of this fight.
Banks: the elephant in the room
This, I believe, is a distraction from the real issue that will determine the future of the euro: banks. For there to be growth there needs to be credit; for there to be credit we need healthy banks, not only to extend new credit but to sustain existing loans.
The US and UK recognised this very early and acted literally overnight to flood the banking system with liquidity. After a financial crisis you have to get the banks moving again if economies are to recover. This requires a central bank that actively plays a role as lender of last resort, and a political leadership that intervenes forcefully in bank restructuring, using public funds in part or full nationalisations, or forcing mergers and closures.
Because confidence is the key to any banking system, these measures by central monetary and political authorities have to be coordinated, decisive and quick.
ECB buries its head in the sand
This is the opposite of how the eurozone has dealt with its financial and sovereign debt crisis. The central bank is ambivalent about its role, knowing it stands as guarantor of financial stability but unwilling to be lender of last resort without the right political responses from its member governments.
The eurozone political leadership is itself fragmented across 17 member governments with their own political ideologies and national self interests that, at times of crisis, create massive conflicts of interest between member countries. Totally absent in the eurozone are any centralised processes for collective decision-making in the collective interest.
Whether to solve fiscal deficits through bailout programmes based on austerity or to mutualise individual country sovereign debt by issuing eurobonds is a pointless debate. Pointless if the banking system is not made healthy, if the European Central Bank (ECB) does not play its lender of last resort role with vigour, and if there are not the centralised political processes that have the legitimacy to make eurozone-wide revenue, spending and borrowing decisions.
What chance is there for growth?
The chances of a fiscally stretched eurozone being able to generate sufficient growth through infrastructure spending or pump priming to restore social cohesion and bring public finances back to health are at best slim. Without a functioning banking system it is dead in the water.
The severe loss and degradation of bank capital remains the bottleneck that has to be removed if growth and a sustainable reduction in public deficits are to be achieved. Instead, with no credible political action from the EU’s leadership, the ECB threatens and cajoles, using the only weapon it has – the prospect of pulling the plug on the whole banking system by withdrawing from its lender-of-last resort role.
Politicians might behave as if this is a hollow threat, a nuclear option that no right-minded central banker would ever use. The problem is that the ordinary people in the street will not hang around to find out if the button is pressed, but will act to protect themselves.
Deposit flight from troubled banks and troubled countries follows, shrinking bank balance sheets, aggravating further their liquidity and capital adequacy problems, and driving them towards even greater dependency on the ECB. Sanctioning a new loan to local entrepreneurs in this environment does not appear high up – or at all – in the priority list for these banks.
Working capital shortage
This is what is happening in Greece. Deposits in Greek banks have fallen from €240 billion in 2009 to around €170 billion today. Greece’s economy is collapsing not only because of the lack of competitiveness and bailout funds to pay wages and pensions, but also from a chronic lack of working capital.
The loss of deposits has left the Greek banks on ECB life support. They are awaiting a €48 billion recapitalisation as part of the bailout programme to make up for the losses they suffered on the ill-thought-out PSI ‘solution’ to the Greek government bond crisis. This recapitalisation is now at risk following the 6 May elections.
And to rub it in, the ECB has stopped providing normal liquidity to Greek banks because of concerns over collateral quality given the outcome of the election. This has forced the local banks to take out Emergency Loan Assistance (ELA) from the Greek central bank estimated at €100 billion.
What ELA means
What difference does it make if the liquidity comes from the Greek central bank or the ECB, you might ask. Liquidity provided directly by the ECB is backed by all members, and the risks shared by all member states. With the ELA, the risks fall fully on the local central bank.
Think about what this says as a statement of confidence by the ECB in your local banks. Think about what this says about the risk of keeping your money in your local bank. No measures – not one – aimed at restoring some hope for the Greek economy or its people will have any chance of succeeding while its banks’ balance sheets continue to shrink, and while capital is used up by deposit flight.
This banking squeeze extends beyond Greece. Overnight deposits in Ireland, Portugal and Spain have also declined since mid 2010; Belgium has witnessed deposit flight, especially around the Dexia problems; so too has France. With banks finding it extremely difficult to raise fresh capital, contraction of bank lending and recession follow.
Amazingly, there is little evidence that policymakers in Europe have recognised that the eurozone banking system needs to be rescued first. Instead, a great deal of political energy is now spent in debating growth compacts, or whether to permit a renegotiation of bailout terms, or whether the austerity chicken comes before the bailout egg.
A squabble over austerity is not the real risk to Greece’s membership of the euro. A bank panic may take this out of the politicians’ hands. And the real risk of a Greek exit – forced or voluntary – is not to Greece. It is that deposit flight spreads to other member countries with troubled banks.
Could a run on the banks spread?
It might not even require a Greek exit to trigger this contagion. If the deposit flight in Greece were to turn into a panic run on Greek banks, depositors in other countries that are seen as being at risk might also take flight. It may be a small country, but Greece could well be the mouse that roared.
This is why the anti-bailout rhetoric from the radical left in Greece, the main winners from the election, and the threats from German politicians in response are worrying. If Greek households panic and start shoving cash into mattresses, the 17 June election may prove an irrelevance, and those who think this crisis can be ring fenced may be in for a rude awakening.
To save the euro policymakers need to move to shore up the banking system. This requires recapitalising the banks with public funds and making the ECB play the role of lender of last resort. Then maybe, just maybe, fiscal and structural policies together with infrastructure investing will have a chance of restoring growth and public finance solvency to the troubled periphery of Europe.
But as luck would have it, just when strong political leadership is required to steer Europe through its worst post-war crisis, the political edifice is crumbling.
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