Merkel’s divisive reunification speech

In her reunification day speech, Angela Merkel unwisely continued to push the line of a two speed Euro, or at least a reconstitution of the currency. This is probably the result of her own belief in what should happen and a need to placate her electorate that, while it undoubtedly does not know the full extent of their contingent liabilities with regard to the Southern states, it does understand the general concepts involved.

On a positive note, Merkel’s announcement that the EUR will be reconfigured has presumably sent a huge signal to the creators of Over-The-Counter (OTC) derivatives that they need to insert a clause in their agreements as they are rolled over with regard to what happened in the event of a EUR break up and we would suggest that while this may lead to higher borrowing costs for the periphery in the near term, at least it will tend to reduce or even remove much of the potential systemic risk associated with a Euro ‘event’ in the long term.

It may therefore be argued that Merkel is implicitly paving the way for a relatively orderly EUR break up in the medium term. But the problem with this ‘medium term’ view is that we must first survive the short term, and Merkel’s comments that the Euro will ultimately fail can only increase the pace of the deposit outflows and general capital flight that is already afflicting the periphery. We have heard suggestions that the Greek banking system has lost some 5% of its deposits since the aborted referendum was announced and we doubt that conditions elsewhere have been much better. This accelerated deposit flight can only have made the solvency of the peripheral banks subject to even more pressure (hence the gapping up in Italian and other bond yields) and it will have exaggerated the intra-regional balance of payments crisis between the core and periphery, thereby placing even more pressure on the embattled TARGET system and the Bundesbank in particular. Merkel’s suggestion that the Euro is a revolving door shows her ignorance of the store of value concept of money (something that has dogged the Euro project since even before its inception) and although Berlusconi’s departure might be seen as a positive for the system, Merkel will have done very much more damage to the system in her reunification speech – the irony seems particularly thick at this point.

With this situation in mind, some commentators now reckon that the Euro has a 25% probability of failure by year end and that by implicitly raising the pressure on the TARGET system and the Bundesbank, Merkel is inviting the media to tell the German public just what is happening, in turn inviting either a political or legal challenge to the Bundesbank’s role in the current de facto QE panic policy in the Euro System, given that there is no repayment date for the Bundesbank’s loans in the TARGET system and only a notional rather than real guarantee.

The nay-sayers argue that even if the Euro does survive into 2012, then it may still have a high probability of being reconstituted following the completion of the Spanish, Italian, Greek and French election cycles. This is because, so the argument goes, that through the elections it will become clear that the bulk of Europe’s voters do not want the failed currency and as this realisation dawns, financial markets will begin to discount such an event.

There would certainly be losers from any reorganisation of the euro, with peripheral banks doubtless suffering acute liquidity problems, and interest rate differentials between the core and periphery would likely remain wide or wider, with the result that exchange controls or limits may be enacted. But these are ‘normal’ market events that can be contained, unlike the situation that might arise in the event of an unexpected breakup that led to systemic failures in the $150 trillion OTC derivative markets.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla