Thursday, June 28, 2012

Crude awakening

Interesting shift.

(WSJ) HOUSTON—America will halve its reliance on Middle East oil by the end of this decade and could end it completely by 2035 due to declining demand and the rapid growth of new petroleum sources in the Western Hemisphere, energy analysts now anticipate.
The shift, a result of technological advances that are unlocking new sources of oil in shale-rock formations, oil sands and deep beneath the ocean floor, carries profound consequences for the U.S. economy and energy security. A good portion of this surprising bounty comes from the widespread use of hydraulic fracturing, or fracking, a technique perfected during the last decade in U.S. fields previously deemed not worth tampering with.
By 2020, nearly half of the crude oil America consumes will be produced at home, while 82% will come from this side of the Atlantic, according to the U.S. Energy Information Administration. By 2035, oil shipments from the Middle East to North America "could almost be nonexistent," the Organization of Petroleum Exporting Countries recently predicted, partly because more efficient car engines and a growing supply of renewable fuel will help curb demand.
The change achieves a long-sought goal of U.S. policy-making: to draw more oil from nearby, stable sources and less from a volatile region half a world away. "Whereas at one point there were real and serious concerns about the ability to maintain sustainable access of supplies to the United States if there were disruptions in the Middle East, that has changed," Carlos Pascual, the top energy official at the State Department, said in an interview.
U.S. officials stress that the Middle East will remain important to American foreign policy partly because of the region's continuing influence on global oil prices. "We need to continue to pay attention to how global markets function, because we have a fundamental interest that those markets are stable," Mr. Pascual said.
That means the U.S. military will keep guarding the region's oil shipping lanes, as it has done for decades. "Nobody else can protect it and if it were no longer available, U.S. oil prices would go up," said Michael O'Hanlon, a national security expert with the Brookings Institution, who says the U.S. spends $50 billion a year protecting oil shipments. But China, a growing consumer of Middle Eastern crude, is seeking a larger presence in the region, with its navy joining antipiracy efforts near Somalia.
Still, growing domestic energy production could allow the U.S. to lessen its focus on the unpredictable region over time. Dependence on Middle East oil has shaped American foreign, national-security and defense policies for most of the last half century. It helped drive the U.S. into active participation in the search for Arab-Israeli peace; drove Washington into close alignments with the monarchies of the Persian Gulf states; compelled it to side with Iraq during its war with Iran; prompted it to then turn against Iraq after its invasion of Kuwait, bringing about the first Persian Gulf war; and prompted Washington to then build up and sustain its military presence in the region.
Whatever the success such strategies had in ensuring American influence in the region, all also came at a price. Involvement in the Arab-Israeli peace process brought the U.S. the enmity of many of the region's most radical forces upset at the failure to create a Palestinian state. The decision to build up an American military presence in the region was used as a rationale for anti-American agitation and attacks by al Qaeda and other extremist forces.
The shift away from Middle Eastern oil means closer ties with Canada, which is emerging as the top U.S. energy ally, but also with Latin neighbors that are strong trading partners. A dollar spent buying oil from these countries is more likely to end up back in the U.S. than a dollar spent buying Iraqi or Saudi crude. Economies buoyed by petrodollars also lessen the appeal of northward migration for Latin America's poor, says Jeremy Martin, director of the energy program at the Institute of the Americas in La Jolla, Calif.
The American energy revolution also is making a splash across the Atlantic. Countries in Eastern Europe, long dependent on Russia for their energy, are seeking to tap their own shale resources with the help of U.S. companies. Even Russia, which needs new sources of oil to maintain its status as an energy superpower, is getting into fracking with the biggest U.S. oil company, Exxon Mobil Corp. This month Exxon and Russia's state-controlled OAO Rosneft broadened an existing alliance to include the joint development of tight oil reserves in western Siberia.
The prospect that new sources of supply in the Americas could lead to years of flat or even falling oil prices is a source of great concern in the Kremlin. Surging oil revenues over his 12 years in power have helped President Vladimir Putin pay for an eightfold increase in government spending, going to everything from pension and wage hikes to costly projects like the Sochi Olympics to a major military buildup. Now, his government is scrambling to find ways to tighten its belt as oil prices—and thus tax revenues—slide. Finding a new driver for Russia's economy is "a colossal challenge," said economy minister Andrei Belousov.
The domestic oil picture has become part of the presidential campaign this year. President Barack Obama likes to point out that output has surged during his first term. "We've added enough new oil and gas pipeline to encircle the Earth and then some," he said in a speech earlier this year. Mitt Romney, the presumed GOP candidate, says the U.S. must do more to promote domestic exploration and says Mr. Obama is holding back the industry. Mr. Romney's campaign ads say that on "Day 1" he will give approval for the Keystone XL pipeline, a project to bring oil from Canada that Mr. Obama's administration has rejected for now.
The renaissance of the U.S. oil patch is pushing down oil prices, giving a boost to the economy at a time when a global slowdown threatens to crimp demand. Research firm Raymond James lowered its 2013 forecast for U.S. crude prices this month to $65 per barrel from $83, partly because production in the U.S. has risen much more quickly than previously expected.
Just the same, obstacles to developing the Western Hemisphere's oil riches remain.
Argentina recently nationalized the assets of Spanish energy giant Repsol SA, arguing that the company wasn't investing enough to develop the country's full oil potential. The action makes investors leery of risking capital there to tap shale-rock formations that could rival booming U.S. oil fields.
In Brazil, where most of the newfound oil lies under thick salt domes far beneath the seabed, a small spill in a Chevron Corp. offshore field led to criminal charges, which Chevron contests. Also, state giant Petroleo Brasileiro SA cut its world-wide 2020 production forecast by 11% earlier this month while estimating that extracting its oil would be more costly than anticipated.
In the U.S., offshore drilling in the Gulf of Mexico is recovering slowly from the impact of the 2010 Deepwater Horizon oil spill.
Still, U.S. government forecasters expect that U.S. petroleum purchases from the Middle East, Africa, and Europe will drop to about 2.5 million barrels a day by 2020, from more than four million barrels today. Oil imports from the Persian Gulf's OPEC members—a group that includes Saudi Arabia, Iraq and Kuwait—will drop to 860,000 barrels a day that year from 1.6 million barrels currently.
Global oil and gas investments tripled between 2003 and 2011, according to IHS Cambridge Energy Research Associates. In the Western Hemisphere, where the U.S. and Canada provided more political stability for investors, they nearly quadrupled. In 2011, 48% of global oil investment, or $320 billion, ended up in the Americas, up from 39% in 2003.
A lot of that money went into the revival of the U.S. oil patch, where energy companies learned to profitably produce oil from tight oil formations by injecting them with high-pressure jets of water mixed with chemicals and sand. The technique has raised concerns with environmentalists who claim it uses too much water and can contaminate water supplies.
First developed in natural-gas fields, fracking yielded an unexpected oil boom that has redrawn America's energy geography. Abundant crude, combined with a huge refining base and waning demand at home turned the U.S. into a net exporter of refined products last year; the EIA expects that situation to continue beyond 2020.
North Dakota went from being a minor producer to surpassing Alaska in March in petroleum output thanks to the Bakken Shale, which is being developed through fracking. Now it is only second to Texas in oil production.
The Bakken, as well as Texas' booming Eagle Ford Shale and the deep-water U.S. Gulf of Mexico, helped average daily U.S. oil production rise 6% between October 2011 and March 2012, topping six million barrels a day for the first time since 1998, the EIA said this month.
"U.S. oil production was for nearly 40 years in total decline, and that decline was never supposed to end," says Jim Burkhard, an analyst with IHS CERA. "This is a major pivot point."
Canada's oil sands—where the earth is drenched in thick, tar-like oil—contain some of the largest quantities of oil in the world but for years they were too expensive to tap. Companies had to mine tons of oil-drenched sand for each barrel of oil, or inject steam deep beneath the earth to make the oil liquid enough for extraction.
As oil prices began to rise, starting in 1999, oil-sands reserves became more profitable, and early investments from Canadian producers like Suncor Energy Inc. and Encana Corp., along with international producers like Royal Dutch Shell PLC turned Canada into the largest oil exporter to the U.S. Later in the decade, international investment poured into Alberta's boreal forest from U.S.-based companies like ConocoPhillips and Exxon Mobil, and Chinese oil companies like Sinopec, PetroChina Co. and CNOOC Ltd.
Deep-water technology enabled Brazil, which for years depended on oil imports, to become a net exporter in 2009. By 2020, Brazil's production is expected to rival Canada's, rising 57% to 4.7 million barrels a day, thanks to some of the largest offshore oil field finds in 30 years.
The drop in American energy imports comes at a time when hundreds of millions in the developing world are beginning to consume more energy as they rise from poverty. "We're very fortunate that this is happening," said Marvin Odum, the president of Shell's U.S. unit, who also heads its exploration and production activities in the Western Hemisphere. "It enables resources to flow to emerging economies."
—Gerald F. Seib, Gregory L. White, Chip Cummins and Keith Johnson contributed to this article.

Wednesday, June 27, 2012

Alam Maritim -- time for bottom fishing?

After falling for the longest time, Alam Maritim share price appears to be stabilizing around $ 0.50 ~ 0.55. The lowest price it ever hit was in 2008, quoted for around $ 0.36.

Moving sideway but in distribution mode usually is not a good sign especially the shares are held by many reputable institutional owners. It may fall off and breakdown during consolidation stage or take a long long time for big guys to distribute. However, institutional ownership is also a reason the share price is relatively more active compared to Sealink. For your information Sealink hit a new all time low.

The question is it a good time to watch or to accumulate?

The company revenue bottomed out in 2010 and incurred losses of 12 million after tax. There was unusual surged of RM 40 million in other expenses in that year but I could not find the reason in the annual report.

What is troubling is not revenue but the gross margin. Declining margins are very serious, it fell from 45% to 19%. It is very troubling indeed. This is definitely not related to under-utilized capacity(note no dramatic increase in depreciation cost). I believe the real trouble is the collapsed of charted rate.

As we all can see in the chart that charter rates above 20 k pounds/day were abnormal. Thus the super-normal profits of year 2008-2009(lagging effects kicked in later) were not real.

The company reported a few good news recently that they bagged new book orders from major oil MNCs. The book orders stood at RM 700 million that will last them 2 - 3 years. From revenue stand point, it is quite safe to say the worst is over - RM 300 to RM 350 million top line is not a problem. The tricky part is the gross margin as it will affect its profitability tremendously.

OSK research is making very aggressive margin recovery assumptions for 2012 and 2013. They assume net profit margin to improve between 15-20%. With that kind of assumption, they are tagging FV of RM 0.70. If they are wrong,  the downside will still persist.

Betting on fundamental recovery is difficult. Thus, stock left with two technical rebound possibilities:

1. News flow of Petronas awarding them contracts for brown field recovery projects.

2. Being acquired when the MA wave is sweeping OSV world. You may note that P/BV is relatively cheap that may attract vultures.

Monday, June 25, 2012

A long trip and finally get to make market comments

I was out in the middle kingdom for almost 2 weeks and felt like eternal and pretty exhausted. As usual, perhaps I was too lazy to find ways to go around to blog when I was there.

It's one of a funny situation we are in. KLCI broke above 1,600 again, unbelievable. Like I said in my previous post before I left, foreign ownership has been in its lowest level and retail investors participation had been very low. So who the hell is in the market? The convenient way or simplest explanation will be the gomen is engineering an artificial support in preparation of a general election. If that is the case, it will be the same group of people(EPF and local fund managers) will dump share later. 

The Greek tragedy turned out to be okay but market faded pretty quickly. The Fed said the economy(the US) is kind of weak but not weak enough to inject drugs(QE) yet. The market pulled back violently.

Crude oil price dipped briefly below USD 80 per barrel. That kind tells us the economic activities pulse is very weak. If this were to go on and on, it will reveal I know and certain of one thing. I don't know anything. :)

However, I still believe that commodity trader is able to price in economic risks better than equity. No sign of turning around of commodity index is still a concern.

There is also no sign of turning around in the Chinese Stock market kind of concern me as well.

During this trip, I observed the restaurants crowd are finally receding. Interest rate cut by Chinese central banker signals something. It needs more than loosening grip to jump start the slowing economy. The PMI reading persistently below 50(contraction)

I am very tempted to rush into economic sensitive stocks/sectors but the indexes are still hardly coming down from its elevated level. Here are some for your information.

I might hit record low posting this month. Don't worry, however, it's not signs of I'm running out of gas but just running out of worthwhile value added commentary. Thank you everyone for the kind comments while I was away. Take care.

Wednesday, June 13, 2012

Stock up, bullishness decrease. Why?

Flip flopping news on media are giving us very confusing signals. Bailouts, not so bad economic data, etc. The most important of all, though many markets have fallen a lot particularly in Europe, Hong Kong, Japan, etc. There are also markets that holding up very well like the US, Malaysia, etc.........

I found a very interesting chart recently. S&P 500 index up but strategist's stock allocation down. If the market direction and bullishness are going up in the same direction then it is something to be worried. If we were to flip the argument, is this telling us everything is okay and even downside risk is relatively minor?

At this point of time, I believe most people are still in the wait and see mode. Undecided - nobody has strong enough motivation to sell or buy. 

Bottomline: strongest market  leaders will have to correct at least 10-15% from the recent highs before picking up stocks, value stocks included.

Monday, June 11, 2012

Is MAS a value play?

MAS share price hit 15 year low. Since it has fallen quite a lot, is MAS a value buy? Following recent disposal of Proton by Knazanah, analysts are speculating MAS can be the next candidate for it to pare down stakes. This was reported by the Star

Analysts looking at various ways to price MAS should a stake sale exercise crop up

The values estimated by analysts are as follow:

OSK RM $ 1.38, 7.5X EV/EBITDA

MIDF RM $ 1.16, 5.9 EV/EBITDAR

Maybank Investment RM $ 0.97, FY 13 10X PER

The perception on MAS's management has been poor. So, there is no need to talk about that. Fail. Some even compare it to our current Barisan Nasional. It will fall through the screening criteria right away based on this criteria. 

The only bet is "reversal" based on crude oil price due to weak global economy. If you look at this table, the ratio of fuel and oil in 2009 and 2010 was between 30 to 32%(relatively weak crude oil price). The ratio gone up to 42% during very strong crude oil price.  

If the crude oil price were to soften and stay around USD 80 bbl, that will translate to about 20% saving. This will translate into 8% profit to the bottom line. Assuming the revenue stay at around RM $ 13 bln, RM $ 1 billion will drop down to the bottom line. 

In 2011, MAS incured losses of RM 2.5 billion and a big sum of RM 1.09 billion was related to write-off, hopefully it was a one time deal. Substracting RM 1.09 billion, MAS will still incurred RM 1.41 billion. Unless MAS is able to cut cost, under doing nothing scenario but help by softer oil price, MAS will still has about RM 400 million losses. To have meaningful profit of RM 500 mln, MAS will need to cut cost by almost RM 1 billion. Can they do it?

Comparing to other regional players by book value multiple, it is still the most expensive. It's almost 4.9 X book value which is unheard off in such a capital intensive business. It is way more expensive compare to one of the best in the world SIA which is only sold for 1 time book value.

Other than betting on some technical rebound, this stock is far from qualified to be a value play. 

Wednesday, June 6, 2012

Buy European Stocks?

If you have access to buy stocks in Singapore, one of the ETFs that can give you exposure to European companies is Lyxor ETF MSCI Europe(LMEU). You might say that I'm crazy, right? Before that, have a look at this information.

Crazy, I'm not. The index is getting closer to 2009 low. I know about the Grexit, the five Pigs and etc.....but these are global companies. To go below 2009 means we are getting into a credit implosion with unknown depth of a black hole. In this case, it's only a regular government bailout or default which I think it is solvable.

Just put it under your watch list and time to pull a trigger will be around 2009 low. If it does breaches 2009 low, like Jim Rogers say always, I hope I'm smart enough to buy more.

Monday, June 4, 2012

EU crisis depends on Germany


Remarks at the Festival of Economics, Trento Italy

Ever since the Crash of 2008 there has been a widespread recognition, both among economists and the general public, that economic theory has failed. But there is no consensus on the causes and the extent of that failure.
I believe that the failure is more profound than generally recognized. It goes back to the foundations of economic theory. Economics tried to model itself on Newtonian physics. It sought to establish universally and timelessly valid laws governing reality. But economics is a social science and there is a fundamental difference between the natural and social sciences. Social phenomena have thinking participants who base their decisions on imperfect knowledge. That is what economic theory has tried to ignore.
Scientific method needs an independent criterion, by which the truth or validity of its theories can be judged. Natural phenomena constitute such a criterion; social phenomena do not. That is because natural phenomena consist of facts that unfold independently of any statements that relate to them. The facts then serve as objective evidence by which the validity of scientific theories can be judged. That has enabled natural science to produce amazing results.
Social events, by contrast, have thinking participants who have a will of their own.  They are not detached observers but engaged decision makers whose decisions greatly influence the course of events. Therefore the events do not constitute an independent criterion by which participants can decide whether their views are valid. In the absence of an independent criterion people have to base their decisions not on knowledge but on an inherently biased and to greater or lesser extent distorted interpretation of reality. Their lack of perfect knowledge or fallibility introduces an element of indeterminacy into the course of events that is absent when the events relate to the behavior of inanimate objects. The resulting uncertainty hinders the social sciences in producing laws similar to Newton’s physics.
Economics, which became the most influential of the social sciences, sought to remove this handicap by taking an axiomatic approach similar to Euclid’s geometry. But Euclid’s axioms closely resembled reality while the theory of rational expectations and the efficient market hypothesis became far removed from it. Up to a point the axiomatic approach worked. For instance, the theory of perfect competition postulated perfect knowledge. But the postulate worked only as long as it was applied to the exchange of physical goods. When it came to production, as distinct from exchange, or to the use of money and credit, the postulate became untenable because the participants’ decisions involved the future and the future cannot be known until it has actually occurred.
I am not well qualified to criticize the theory of rational expectations and the efficient market hypothesis because as a market participant I considered them so unrealistic that I never bothered to study them. That is an indictment in itself but I shall leave a detailed critique of these theories to others.
Instead, I should like to put before you a radically different approach to financial markets. It was inspired by Karl Popper who taught me that people’s interpretation of reality never quite corresponds to reality itself. This led me to study the relationship between the two. I found a two-way connection between the participants’ thinking and the situations in which they participate. On the one hand people seek to understand the situation; that is the cognitive function. On the other, they seek to make an impact on the situation; I call that the causative or manipulative function. The two functions connect the thinking agents and the situations in which they participate in opposite directions. In the cognitive function the situation is supposed to determine the participants’ views; in the causative function the participants’ views are supposed to determine the outcome. When both functions are at work at the same time they interfere with each other. The two functions form a circular relationship or feedback loop. I call that feedback loop reflexivity. In a reflexive situation the participants’ views cannot correspond to reality because reality is not something independently given; it is contingent on the participants’ views and decisions. The decisions, in turn, cannot be based on knowledge alone; they must contain some bias or guess work about the future because the future is contingent on the participants’ decisions.
Fallibility and reflexivity are tied together like Siamese twins. Without fallibility there would be no reflexivity – although the opposite is not the case: people’s understanding would be imperfect even in the absence of reflexivity. Of the two twins, fallibility is the first born. Together, they ensure both a divergence between the participants’ view of reality and the actual state of affairs and a divergence between the participants’ expectations and the actual outcome.
Obviously, I did not discover reflexivity. Others had recognized it before me, often under a different name. Robert Merton wrote about self-fulfilling prophecies and the bandwagon effect, Keynes compared financial markets to a beauty contest where the participants had to guess who would be the most popular choice. But starting from fallibility and reflexivity I focused on a problem area, namely the role of misconceptions and misunderstandings in shaping the course of events that mainstream economics tried to ignore. This has made my interpretation of reality more realistic than the prevailing paradigm.
Among other things, I developed a model of a boom-bust process or bubble which is endogenous to financial markets, not the result of external shocks. According to my theory, financial bubbles are not a purely psychological phenomenon.  They have two components: a trend that prevails in reality and a misinterpretation of that trend. A bubble can develop when the feedback is initially positive in the sense that both the trend and its biased interpretation are mutually reinforced. Eventually the gap between the trend and its biased interpretation grows so wide that it becomes unsustainable. After a twilight period both the bias and the trend are reversed and reinforce each other in the opposite direction. Bubbles are usually asymmetric in shape: booms develop slowly but the bust tends to be sudden and devastating. That is due to the use of leverage: price declines precipitate the forced liquidation of leveraged positions.
Well-formed financial bubbles always follow this pattern but the magnitude and duration of each phase is unpredictable. Moreover the process can be aborted at any stage so that well-formed financial bubbles occur rather infrequently.
At any moment of time there are myriads of feedback loops at work, some of which are positive, others negative. They interact with each other, producing the irregular price patterns that prevail most of the time; but on the rare occasions that bubbles develop to their full potential they tend to overshadow all other influences.
According to my theory financial markets may just as soon produce bubbles as tend toward equilibrium. Since bubbles disrupt financial markets, history has been punctuated by financial crises. Each crisis provoked a regulatory response. That is how central banking and financial regulations have evolved, in step with the markets themselves. Bubbles occur only intermittently but the interplay between markets and regulators is ongoing. Since both market participants and regulators act on the basis of imperfect knowledge the interplay between them is reflexive. Moreover reflexivity and fallibility are not confined to the financial markets; they also characterize other spheres of social life, particularly politics. Indeed, in light of the ongoing interaction between markets and regulators it is quite misleading to study financial markets in isolation. Behind the invisible hand of the market lies the visible hand of politics. Instead of pursuing timeless laws and models we ought to study events in their time bound context.
My interpretation of financial markets differs from the prevailing paradigm in many ways. I emphasize the role of misunderstandings and misconceptions in shaping the course of history. And I treat bubbles as largely unpredictable. The direction and its eventual reversal are predictable; the magnitude and duration of the various phases is not. I contend that taking fallibility as the starting point makes my conceptual framework more realistic. But at a price: the idea that laws or models of universal validity can predict the future must be abandoned.
Until recently, my interpretation of financial markets was either ignored or dismissed by academic economists. All this has changed since the crash of 2008. Reflexivity became recognized but, with the exception of Imperfect Knowledge Economics, the foundations of economic theory have not been subjected to the profound rethinking that I consider necessary. Reflexivity has been accommodated by speaking of multiple equilibria instead of a single one. But that is not enough. The fallibility of market participants, regulators, and economists must also be recognized.  A truly dynamic situation cannot be understood by studying multiple equilibria.  We need to study the process of change.
The euro crisis is particularly instructive in this regard. It demonstrates the role of misconceptions and a lack of understanding in shaping the course of history. The authorities didn’t understand the nature of the euro crisis; they thought it is a fiscal problem while it is more of a banking problem and a problem of competitiveness. And they applied the wrong remedy: you cannot reduce the debt burden by shrinking the economy, only by growing your way out of it. The crisis is still growing because of a failure to understand the dynamics of social change; policy measures that could have worked at one point in time were no longer sufficient by the time they were applied.
Since the euro crisis is currently exerting an overwhelming influence on the global economy I shall devote the rest of my talk to it. I must start with a warning: the discussion will take us beyond the confines of economic theory into politics and the dynamics of social change. But my conceptual framework based on the twin pillars of fallibility and reflexivity still applies. Reflexivity doesn’t always manifest itself in the form of bubbles. The reflexive interplay between imperfect markets and imperfect authorities goes on all the time while bubbles occur only infrequently. This is a rare occasion when the interaction exerts such a large influence that it casts its shadow on the global economy. How could this happen? My answer is that there is a bubble involved, after all, but it is not a financial but a political one. It relates to the political evolution of the European Union and it has led me to the conclusion that the euro crisis threatens to destroy the European Union. Let me explain.
I contend that the European Union itself is like a bubble. In the boom phase the EU was what the psychoanalyst David Tuckett calls a “fantastic object” – unreal but immensely attractive. The EU was the embodiment of an open society –an association of nations founded on the principles of democracy, human rights, and rule of law in which no nation or nationality would have a dominant position. 
The process of integration was spearheaded by a small group of far sighted statesmen who practiced what Karl Popper called piecemeal social engineering. They recognized that perfection is unattainable; so they set limited objectives and firm timelines and then mobilized the political will for a small step forward, knowing full well that when they achieved it, its inadequacy would become apparent and require a further step. The process fed on its own success, very much like a financial bubble. That is how the Coal and Steel Community was gradually transformed into the European Union, step by step.
Germany used to be in the forefront of the effort. When the Soviet empire started to disintegrate, Germany’s leaders realized that reunification was possible only in the context of a more united Europe and they were willing to make considerable sacrifices to achieve it.  When it came to bargaining they were willing to contribute a little more and take a little less than the others, thereby facilitating agreement.  At that time, German statesmen used to assert that Germany has no independent foreign policy, only a European one.
The process culminated with the Maastricht Treaty and the introduction of the euro. It was followed by a period of stagnation which, after the crash of 2008, turned into a process of disintegration. The first step was taken by Germany when, after the bankruptcy of Lehman Brothers, Angela Merkel declared that the virtual guarantee extended to other financial institutions should come from each country acting separately, not by Europe acting jointly. It took financial markets more than a year to realize the implication of that declaration, showing that they are not perfect.
The Maastricht Treaty was fundamentally flawed, demonstrating the fallibility of the authorities. Its main weakness was well known to its architects: it established a monetary union without a political union. The architects believed however, that when the need arose the political will could be generated to take the necessary steps towards a political union.
But the euro also had some other defects of which the architects were unaware and which are not fully understood even today. In retrospect it is now clear that the main source of trouble is that the member states of the euro have surrendered to the European Central Bank their rights to create fiat money. They did not realize what that entails – and neither did the European authorities. When the euro was introduced the regulators allowed banks to buy unlimited amounts of government bonds without setting aside any equity capital; and the central bank accepted all government bonds at its discount window on equal terms. Commercial banks found it advantageous to accumulate the bonds of the weaker euro members in order to earn a few extra basis points. That is what caused interest rates to converge which in turn caused competitiveness to diverge. Germany, struggling with the burdens of reunification, undertook structural reforms and became more competitive. Other countries enjoyed housing and consumption booms on the back of cheap credit, making them less competitive. Then came the crash of 2008 which created conditions that were far removed from those prescribed by the Maastricht Treaty. Many governments had to shift bank liabilities on to their own balance sheets and engage in massive deficit spending. These countries found themselves in the position of a third world country that had become heavily indebted in a currency that it did not control. Due to the divergence in economic performance Europe became divided between creditor and debtor countries. This is having far reaching political implications to which I will revert.
It took some time for the financial markets to discover that government bonds which had been considered riskless are subject to speculative attack and may actually default; but when they did, risk premiums rose dramatically. This rendered commercial banks whose balance sheets were loaded with those bonds potentially insolvent. And that constituted the two main components of the problem confronting us today: a sovereign debt crisis and a banking crisis which are closely interlinked.
The eurozone is now repeating what had often happened in the global financial system. There is a close parallel between the euro crisis and the international banking crisis that erupted in 1982. Then the international financial authorities did whatever was necessary to protect the banking system: they inflicted hardship on the periphery in order to protect the center. Now Germany and the other creditor countries are unknowingly playing the same role. The details differ but the idea is the same: the creditors are in effect shifting the burden of adjustment on to the debtor countries and avoiding their own responsibility for the imbalances. Interestingly, the terms “center” and “periphery” have crept into usage almost unnoticed. Just as in the 1980’s all the blame and burden is falling on the “periphery” and the responsibility of the “center” has never been properly acknowledged.  Yet in the euro crisis the responsibility of the center is even greater than it was in 1982. The “center” is responsible for designing a flawed system, enacting flawed treaties, pursuing flawed policies and always doing too little too late. In the 1980’s Latin America suffered a lost decade; a similar fate now awaits Europe. That is the responsibility that Germany and the other creditor countries need to acknowledge. But there is no sign of this happening.
The European authorities had little understanding of what was happening. They were prepared to deal with fiscal problems but only Greece qualified as a fiscal crisis; the rest of Europe suffered from a banking crisis and a divergence in competitiveness which gave rise to a balance of payments crisis. The authorities did not even understand the nature of the problem, let alone see a solution. So they tried to buy time.
Usually that works. Financial panics subside and the authorities realize a profit on their intervention. But not this time because the financial problems were reinforced by a process of political disintegration. While the European Union was being created, the leadership was in the forefront of further integration; but after the outbreak of the financial crisis the authorities became wedded to preserving the status quo. This has forced all those who consider the status quo unsustainable or intolerable into an anti-European posture. That is the political dynamic that makes the disintegration of the European Union just as self-reinforcing as its creation has been.  That is the political bubble I was talking about.
At the onset of the crisis a breakup of the euro was inconceivable: the assets and liabilities denominated in a common currency were so intermingled that a breakup would have led to an uncontrollable meltdown. But as the crisis progressed the financial system has been progressively reordered along national lines. This trend has gathered momentum in recent months. The Long Term Refinancing Operation (LTRO) undertaken by the European Central Bank enabled Spanish and Italian banks to engage in a very profitable and low risk arbitrage by buying the bonds of their own countries. And other investors have been actively divesting themselves of the sovereign debt of the periphery countries.
If this continued for a few more years a break-up of the euro would become possible without a meltdown – the omelet could be unscrambled – but it would leave the central banks of the creditor countries with large claims against the central banks of the debtor countries which would be difficult to collect. This is due to an arcane problem in the euro clearing system called Target2. In contrast to the clearing system of the Federal Reserve, which is settled annually, Target2 accumulates the imbalances. This did not create a problem as long as the interbank system was functioning because the banks settled the imbalances themselves through the interbank market. But the interbank market has not functioned properly since 2007 and the banks relied increasingly on the Target system. And since the summer of 2011 there has been increasing capital flight from the weaker countries. So the imbalances grew exponentially. By the end of March this year the Bundesbank had claims of some 660 billion euros against the central banks of the periphery countries.
The Bundesbank has become aware of the potential danger. It is now engaged in a campaign against the indefinite expansion of the money supply and it has started taking measures to limit the losses it would sustain in case of a breakup. This is creating a self-fulfilling prophecy. Once the Bundesbank starts guarding against a breakup everybody will have to do the same.
This is already happening. Financial institutions are increasingly reordering their European exposure along national lines just in case the region splits apart. Banks give preference to shedding assets outside their national borders and risk managers try to match assets and liabilities within national borders rather than within the eurozone as a whole. The indirect effect of this asset-liability matching is to reinforce the deleveraging process and to reduce the availability of credit, particularly to the small and medium enterprises which are the main source of employment.
So the crisis is getting ever deeper. Tensions in financial markets have risen to new highs as shown by the historic low yield on Bunds. Even more telling is the fact that the yield on British 10 year bonds has never been lower in its 300 year history while the risk premium on Spanish bonds is at a new high.
The real economy of the eurozone is declining while Germany is still booming. This means that the divergence is getting wider. The political and social dynamics are also working toward disintegration. Public opinion as expressed in recent election results is increasingly opposed to austerity and this trend is likely to grow until the policy is reversed. So something has to give.
In my judgment the authorities have a three months’ window during which they could still correct their mistakes and reverse the current trends. By the authorities I mean mainly the German government and the Bundesbank because in a crisis the creditors are in the driver’s seat and nothing can be done without German support.
I expect that the Greek public will be sufficiently frightened by the prospect of expulsion from the European Union that it will give a narrow majority of seats to a coalition that is ready to abide by the current agreement. But no government can meet the conditions so that the Greek crisis is liable to come to a climax in the fall. By that time the German economy will also be weakening so that Chancellor Merkel will find it even more difficult than today to persuade the German public to accept any additional European responsibilities. That is what creates a three months’ window.
Correcting the mistakes and reversing the trend would require some extraordinary policy measures to bring conditions back closer to normal, and bring relief to the financial markets and the banking system. These measures must, however, conform to the existing treaties. The treaties could then be revised in a calmer atmosphere so that the current imbalances will not recur. It is difficult but not impossible to design some extraordinary measures that would meet these tough requirements. They would have to tackle simultaneously the banking problem and the problem of excessive government debt, because these problems are interlinked. Addressing one without the other, as in the past, will not work.
Banks need a European deposit insurance scheme in order to stem the capital flight. They also need direct financing by the European Stability Mechanism (ESM) which has to go hand-in-hand with eurozone-wide supervision and regulation. The heavily indebted countries need relief on their financing costs. There are various ways to provide it but they all need the active support of the Bundesbank and the German government.
That is where the blockage is. The authorities are working feverishly to come up with a set of proposals in time for the European summit at the end of this month. Based on the current newspaper reports the measures they will propose will cover all the bases I mentioned but they will offer only the minimum on which the various parties can agree while what is needed is a convincing commitment to reverse the trend. That means the measures will again offer some temporary relief but the trends will continue. But we are at an inflection point.  After the expiration of the three months’ window the markets will continue to demand more but the authorities will not be able to meet their demands.
It is impossible to predict the eventual outcome. As mentioned before, the gradual reordering of the financial system along national lines could make an orderly breakup of the euro possible in a few years’ time and, if it were not for the social and political dynamics, one could imagine a common market without a common currency. But the trends are clearly non-linear and an earlier breakup is bound to be disorderly. It would almost certainly lead to a collapse of the Schengen Treaty, the common market, and the European Union itself. (It should be remembered that there is an exit mechanism for the European Union but not for the euro.) Unenforceable claims and unsettled grievances would leave Europe worse off than it was at the outset when the project of a united Europe was conceived.
But the likelihood is that the euro will survive because a breakup would be devastating not only for the periphery but also for Germany. It would leave Germany with large unenforceable claims against the periphery countries. The Bundesbank alone will have over a trillion euros of claims arising out of Target2 by the end of this year, in addition to all the intergovernmental obligations. And a return to the Deutschemark would likely price Germany out of its export markets – not to mention the political consequences. So Germany is likely to do what is necessary to preserve the euro – but nothing more. That would result in a eurozone dominated by Germany in which the divergence between the creditor and debtor countries would continue to widen and the periphery would turn into permanently depressed areas in need of constant transfer of payments. That would turn the European Union into something very different from what it was when it was a “fantastic object” that fired peoples imagination. It would be a German empire with the periphery as the hinterland.
I believe most of us would find that objectionable but I have a great deal of sympathy with Germany in its present predicament. The German public cannot understand why a policy of structural reforms and fiscal austerity that worked for Germany a decade ago will not work Europe today. Germany then could enjoy an export led recovery but the eurozone today is caught in a deflationary debt trap. The German public does not see any deflation at home; on the contrary, wages are rising and there are vacancies for skilled jobs which are eagerly snapped up by immigrants from other European countries. Reluctance to invest abroad and the influx of flight capital are fueling a real estate boom. Exports may be slowing but employment is still rising. In these circumstances it would require an extraordinary effort by the German government to convince the German public to embrace the extraordinary measures that would be necessary to reverse the current trend. And they have only a three months’ window in which to do it.
We need to do whatever we can to convince Germany to show leadership and preserve the European Union as the fantastic object that it used to be. The future of Europe depends on it.