The Sun Will Set on Electric Utilities
Two technologies—better batteries and local distribution networks—threaten the legacy electric utilities.
Half of electric-utility executives surveyed recently expect their industry to go into a “death spiral” within 10 years, a trade journal reports. Those executives manage companies with big capital-spending programs, high dividend-payout ratios, and scant prospects of raising their sales volumes.
Don’t blame the Great Recession. Electricity sales have barely increased in the seven-year upturn after the economy hit bottom. And don’t blame competition from rooftop solar collectors. The decoupling of electric sales and economic activity began decades ago.
You can blame economic efficiency. Americans have learned to do more with less, and U.S. industry has switched from making electricity-guzzling basic products to products with more value added.
Sure, the electric car is coming. That could increase demand, raising kilowatt-hour sales by 15% if half of the vehicles in the U.S. charged up instead of filled up. But another trend is more depressing for utilities: If Americans converted to LED lighting, that would reduce sales by 10%.
Why do electric companies spend so much on new plants when consumers show so little inclination to buy more of the output?
From 2000 to the present, investor-owned utilities doubled their equity base while kilowatt-hour sales rose less than 10%. The more they invest, the more they can earn, so they have an incentive to invest when regulators allow them to earn more than the cost of capital.
If sales do not increase, how will they earn additional profits to cover the cost of the new investment? They can cut costs or raise prices, of course. They have cut costs for two decades. Now it looks as if they will have to raise prices, working through the slow state-regulatory process.
They might have to raise prices for a kilowatt-hour just as the introduction of disruptive technologies might give consumers an alternative to the legacy electricity provider. That’s the death spiral: Utilities raise prices, making an easier entry for competitive products, then utilities lose sales and must raise prices more to pay for all of the overhead they installed unnecessarily, and competitors take still more of the market.
That brings up the electric company’s peculiar relationship with its customers. Electricity consumers do not line up the night before to buy power. They have no thoughts about the electric company while the lights are on and only the worst thoughts when the lights go out. They may stick to the local utility’s electricity retailer—but largely out of inertia, or because they never heard of the competitors, or they don’t believe any action offers anything worth the effort of switching.
But what happens when the competitive supplier of a product that reduces usage or substitutes for the legacy utility has the name recognition, deep pockets, or marketing smarts of Google, Apple, or SolarCity? Will consumers still stick with the local utility?
TWO TECHNOLOGIES threaten the grid-based legacy utilities and traditional power producers. The first is storage, probably in the form of improved lithium-ion batteries. Better batteries would permit renewable-energy producers to store the energy they produce until it can be sold when needed. That technology would make renewables as reliable as conventional power plants and put many older and dirtier plants out of business.
Batteries could enable big consumers or groups of small consumers to store electricity for local use, reducing the need for transmission projects and the need for expensive generating capacity to meet peak loads.
From there, it’s a short step to a microgrid, in which local customers band together to distribute electricity, and possibly even to produce and store power. They might cut themselves off from the grid opportunistically or operate in total independence from the grid. If the former, they will take away high-profit sales from the legacy utility. If the latter, they may take customers away entirely.
These two developments will gain traction as soon as commercial or municipal entities see an economic advantage in developing them. They do not require anyone to persuade the mass of consumers to take action.
Two decades of deregulation should have made this industry attentive to consumers’ needs, lowering costs and making companies more competitive. Unfortunately, deregulation never lived up to the expectations of its proponents. New merchant power-generation firms borrowed heavily in anticipation of future business that never materialized, and most went under. Merchant transmission building never even got off the ground.
Deregulation promised to shift financial risk onto the backs of the builders where it belonged. Nowadays, transmission and generation projects require long-term contracts reconnecting the consumers and builders—a structure that effectively replicates regulation.
As for lower prices, after almost two decades, prices in deregulated states are just as high in relation to prices elsewhere as they were when the process began. But one thing did change—debt levels. The electric-utility industry is now more heavily leveraged and thus in a weaker overall financial position—on the eve of dramatic challenges.
The current wave of utility mergers and acquisitions, wherein generation companies are scooping up fully regulated entities at hefty premiums in order to increase their relative proportion of regulated assets, is a tacit admission of failure.
As deregulators expected, the grid-based electricity industry’s business strategy of piling capital into a stagnant market and expecting customers to pay more for the same service becomes unsustainable once alternate providers can undercut the grid’s offerings.
The process has already begun. Utilities hoped that deregulation for them would become the proverbial goose that laid golden eggs. Instead, it has made them and their investors sitting ducks.
Turmoil in U.K. Property Market Creates Values
As asset managers struggle to meet redemptions, some property funds and REITs look oversold. Hammerson’s hefty dividend yield
Commercial real estate is one of the perceived losers after the United Kingdom voted last month to leave the European Union. If British consumers tighten their purse strings and employers shift jobs out of the U.K., demand for retail and office space could fall, reducing the yields that investors earn from commercial real-estate funds.
Yet, a sudden and violent selloff in property assets has created value for long-term investors. For retail investors looking to gain exposure to commercial real estate, options include open-end funds, publicly traded real estate investment trusts, and closed-end funds.
The U.K. real-estate market currently offers a 3.8% yield, in line with the global market. That is more than four times the 0.78% on the 10-year U.K. bond, while yields are negative on debt of similar maturity in perceived European havens, such as Switzerland and Germany.
With investors attempting to yank money last week out of open-end funds, which hold about 25 billion pounds ($32.3 billion) in U.K. property assets, a number of asset-management firms suspended withdrawals to give themselves time to meet redemptions. Even with as much as 15% of their assets in cash, these funds were unable to meet investors’ demands for money. Redemption attempts reached levels not seen since the 2008 financial crisis.
FUNDS THAT SUSPENDED withdrawals include £4.4 billion M&G Property (ticker: B4PRMF-F.UK) and £3.9 billion Henderson U.K. Property Authorised Investment (RH7P4N-F.UK).
Aberdeen Asset Management (ADN.UK) took a somewhat different approach. After briefly suspending redemptions from its £3.2 billion Aberdeen U.K. Property fund (L5BT8X-F.U.K.), it implemented a “dilution adjustment” that reduced the dealing price by 17%. Then it allowed redemptions to resume. “It is imperative that we protect remaining holders by fairly reflecting the impact of short-term trading on values provided to redeeming shareholders,” Aberdeen Chief Executive Martin Gilbert said.
The disadvantage of open-end real-estate funds, which put investors’ money directly into property, is that assets might need to be sold to meet redemptions. This process can take time. In contrast, investors can buy and sell shares in closed-end funds and REITs with no impact on the underlying assets.
If open-end funds are forced to sell real estate to meet redemptions, prices could weaken. This could lead property experts to reduce REIT valuations by year end. Mark Ebert, who manages Quaero Capital’s real-assets fund, expects sell-side analysts to downgrade earnings forecasts and net asset values.
But U.K. REITs are already trading at a 27.2% discount to net asset value, he estimates, after being “efficiently adjusted downwards.”
London-listed real estate investment trusts have been battered since the unexpected result of the June 23 Brexit referendum. Shares of the REIT components of the benchmark FTSE 100 index— Land Securities Group (LAND.UK), British Land (BLND.UK), Hammerson (HMSO.UK), and Intu Properties (INTU.UK)—have tumbled by 12% to 23% since the Brexit vote. In the same period, the broader FTSE 100 has climbed 4%.
Peter Clark, a portfolio manager at Investec Asset Management, says that U.K. REITs are pricing in a 20% decline in real-estate values. “We think this is reasonable,” he says.
THE SHIFT IN SENTIMENT toward U.K. property brings an abrupt halt to a rosy period for the sector. Investors had been lured by attractive returns in recent years, at a time when the fixed-income crowd was scratching around for yield. They have been particularly keen to reduce their exposure to London office space, which could be especially vulnerable in a downturn.
Nonetheless, there are reasons for optimism. If open-end funds need to sell properties to raise liquidity, the market could absorb some sales. Transactions last year were £15 billion a quarter, although they are likely to be weaker in 2016.
In addition, there is no evidence that the banks are unwilling to lend on U.K. property, or that investors are overleveraged. Loans as a percentage of asset values are no higher than 60% to 65% for all types of properties. In 2006-07, loans commonly reached 90% of valuations. For U.K. REITs, the loan-to-value figure currently runs at 30%, on average.
Hammerson looks oversold. The company has a big presence in the U.K., but its portfolio includes prime shopping centers and retail parks across continental Europe. About 40% of its earnings are in euros, so it is less concentrated than some of its rivals. On top of that, it offers a dividend yield of 4.4%, which provides protection against further downside. The shares closed Friday at £5.18.
Weekly Market Update: Investors Find Brexit Solace in US Equities & Government Bonds
Global financial markets remained volatile under the continuing influence of the UK Brexit vote two weeks ago. The 10-year UST yield sank to fresh record lows below 1.35%, and buyers of 50-year Swiss government bonds got ready to accept a negative yield this week as malaise settled over the entire global economy. The pound, which hit a 31-year low against the dollar of 1.2800 on July 6th, gave up recent gains and sank back below 1.3000, while the dollar and yen remained strong. Crude prices sank lower, with WTI back in the $45 handle and Brent back around $46. In the UK, various investment firms suspended redemptions in open-ended property funds as investors rushed to take out their cash, while investors eyed the Italian banking system with deepening concern. On Friday, the very strong June US jobs report lifted stocks broadly to flirt with all-time highs in the S&P. US Treasury yields stayed stubbornly low, as global demand for assets that offer any kind of relative yield remains unwavering. For the week, the DJIA +1.1%, the S&P500 +1.3% and the Nasdaq +1.9%.
The June US jobs report was very strong and may have been good enough to bring forward Fed rate hike expectations after the setback of Brexit. The 287K non-farm gain was way ahead of even the most optimistic estimates, although the result only brings the Q2 average up to +147K, versus +196K in Q1. Unemployment ticked up to 4.9% from 4.7%, however the household survey showed an incremental decline in labor market slack as the participation rate ticked slightly higher.
Global currency markets remained under pressure from the Brexit vote. Sterling slid lower on Monday and Tuesday, then appeared to stabilize around 30-year lows in the second half of the week, but remained firmly below 1.3000. The yen remained a safe haven, with funds flowing into the Japanese currency despite some weak economic data reports. USD/JPY had traded back up to 103.25 last week, but as of Friday the pair was back to the critical 100 level, which was briefly breached during the Brexit vote panic and subsequently held unchallenged. The volatility prompted Vice Finance Minister & FX Chief Asakawa to warn the government was "closely watching" FX markets with urgency and would act promptly if there were "speculative moves." EUR/USD was steadier and held above the 1.100 level.
The second-order effects of the Brexit vote further dampened confidence. Seven UK investment firms suspended trading in property funds this week, freezing £15 billion of assets since Monday, out of a total of £24 billion invested in UK open-end real estate funds. Many comparisons were made to the failure of Bear Stearns' hedge funds in the summer of 2007, although the total amount held in such property funds is extremely modest. Press reports asserted that funds Henderson, Columbia Threadneedle and Aberdeen were maintaining positive cash balances but chose to halt withdrawals to "protect" investors.
The ongoing selloff in the Italian bank stocks continued apace, leading the nation's market regulators to ban short selling of shares of Banca Monte Paschi for three months. Italy's banks are burdened by €360 billion of non-performing loans, the equivalent of a fifth of the country's GDP. Collectively they have provisioned for only 45% of that amount. With shares sinking faster post-Brexit vote, there is building pressure for more bail-in funding for the system, and there were reports the government would set up a second fund - dubbed Atlante 2, with €3-5 billion in capital, after the Atlante fund set up earlier this year - to help clean up the mess.
The yuan weakened for the fifth week in a row, marking the longest losing streak for the Chinese currency this year. USD/CNY has risen to 6.6873, the yuan's weakest setting against the greenback since the first quarter of 2010. The June China FX report disclosed the biggest one-month gain in reserves in over 12 months, leading many participants to speculate that the PBoC has halted its regular FX market interventions and allowed the yuan to weaken in its quest to revive economic growth. The currency also saw its biggest weekly drop against a trade-weighted basket of 13 currencies in four weeks, another sign that Beijing has become tolerant of further declines. There was little hard data out this week - the Hong Kong PMI contracted for the 16th straight month in June as conditions deteriorated to their worst level since last summer - but speculation about PBoC rate cuts heated up and many analysts are saying another cycle of RRR cuts is in the offing in the second half of 2016.
The contagion of political uncertainty has infected another major economy, this time Australia. Last Sunday, Australians went to the polls to elect a new federal parliament, and almost a week later, Liberal/National Coalition and Labor remain basically deadlocked. The Australian Electoral Commission is recounting all ballots before announcing the official result, and as of Friday the conservative National Coalition is leading with 74 seats, followed by the Labor Party with 71, with the former ceding at least 16 seats to the latter. It appears that National Coalition will most likely be forming a government, but S&P lowered their outlook on Australia's AAA rating to negative from stable on Thursday as the lack of a strong mandate potentially dinged the future government's prospects for reining in the budget deficit.
Retailers reported much improved sales comps for the month of June. The Father's Day holiday on June 19, a calendar shift reporting the sales of Memorial Day weekend in June and good weather all contributed to boosting the month's business. Gap disclosed its first positive monthly comps report of 2016, with Old Navy posting a +5% comp. After flattish April and May SSS, L Brands posted an increase of 6%. The numbers may herald a third month of good total US retail sales (the June US retail sales report drops next Friday), after much better than expected April and May retail sales. However, many other retail comp sales reports remained deep in the red, with Zumiez, Buckle and Cosi reporting terrible numbers.
Closing Market Summary: Stocks Rally on June Jobs Report
The stock market ended an abbreviated week on a higher note as a positive reading of the Employment Situation Report for June brought the S&P 500 (+1.5%) within 0.1% of its all-time intraday high (2134.72). The upbeat June employment report sparked a risk rally, indicating a rebound in the labor market without prompting speculation regarding a sooner-than-expected move from the Fed. Additionally, a rebound in oil futures, softening in the dollar, and sector leadership from the heavily-weighted industrial (+1.9%), financial (+1.8%), consumer discretionary (+1.8%), and technology (+1.7%) sectors added to sustained buying interest. The Nasdaq Composite (+1.6%) ended its day ahead of the S&P 500 (+1.5%) and the Dow Jones Industrial Average (+1.4%).
Today's session began on a higher note as a positive reading of the Employment Situation Report for June alleviated concerns regarding weakness in the U.S. labor market. The report showed that both nonfarm payrolls (287K; consensus 175K) and nonfarm private payrolls (265k; consensus 170k) rebounded from disappointing May readings. However, the positive data failed to spark rate hike fears as negative revisions to May's readings, weak average hourly earnings growth, and global uncertainty weigh on rate hike expectations.
The major averages extended their advance through the session as the heavyweight industrial (+1.9%), financial (+1.8%), and consumer discretionary (+1.8%) sectors followed materials (+2.5%) on the leaderboard. The benchmark index notched a session high (2131.71) shortly before the final hour of trade, falling short of an all-time high. The S&P 500 (+1.5%) finished with all ten sectors in positive territory as defensive sectors underperformed. Countercyclical utilities (+1.0%), consumer staples (+1.0%), telecom services (+1.0%) rounded out the leaderboard.
The Dow Jones Transportation Average (+2.6%) finished ahead of the broader market as rail names and airlines demonstrated relative strength. On that note, Norfolk Southern (NSC 86.42, +2.38) and Union Pacific (UNP 90.69, +2.66) jumped 2.8% and 3.0%, respectively. Separately, Avis Budget (CAR 34.61, +3.71) outperformed after Hertz Global (HTZ 47.90, +4.41) disclosed that it signed confidentiality agreements with Carl Icahn and other parties.
The economically-sensitive financial sector (+1.8%) outperformed as credit service names and life insurance companies topped the space. In the group, Capital One (COF 64.71, +2.82) jumped 4.6% after receiving an upgrade at DA Davidson from "Neutral" to "Buy." Elsewhere, MetLife (MET 39.20, +0.93) rallied 2.4% after disclosing that its wholly-owned Hong Kong subsidiary grew by 116% year-over-year in the first quarter. The broader sector gained 1.8% today, erasing a modest weekly loss to finish higher by 0.8%.
The energy sector (+1.3%) finished behind the broader market as the space recovered from sharp weekly losses in oil. The energy component ended its day higher by 0.4% ($45.36/bbl; +$0.17), narrowing its weekly loss to 7.5%. In the group, Baker Hughes (BHI 43.69, +0.15) ticked higher by 0.3% after announcing that its international rig count fell to 927 in June (from 955 in May). Separately, Dow component Exxon Mobil (XOM 93.54, +0.58) finished higher by 0.6%.
The U.S. Dollar Index (96.26, -0.06) ended modestly lower as the yen and the pound gained against the buck. Sterling gained 0.4% against the dollar (1.2953) while the dollar/yen pair finished lower by 0.3% (100.47). On the flipside, the single currency lost 0.1% against the dollar (1.1054).
The Treasury complex ended on a mixed note as the yield on the 10-yr note slipped three basis point to 1.36%. Conversely, the yield on the short-term 2-yr note rose two basis points to 0.61%.
Today's participation was above the recent average as more than 906 million shares changed hands on the NYSE floor.
Today's economic data included the Employment Situation Report for June and Consumer Credit for May:
- The June Employment Situation report was a big beat at first glance, but a dive below the surface shows some soft spots in the overall employment picture.
- Nonfarm payrolls increased by 287,000 (consensus 180,000).
- Over the past three months, job gains have averaged 147,000 per month
- May nonfarm payrolls revised to 11,000 from 38,000
- April nonfarm payrolls revised to 144,000 from 123,000
- Private sector payrolls increased by 265,000 (consensus 178,000)
- May private sector payrolls revised to -6,000 from 25,000
- The unemployment rate was 4.9% (consensus 4.8%) versus 4.7% in May
- Persons unemployed for 27 weeks or more accounted for 25.8% of the unemployed versus 25.1% in May
- June average hourly earnings were up 0.1% (consensus 0.2%) after being up 0.2% in May
- Over the last 12 months, average hourly earnings have risen 2.6%
- Aggregate earnings were up 0.2% on top of a downwardly revised unchanged reading in May (from 0.2%)
- The average workweek was 34.4 hours (consensus 34.4) versus 34.4 in May
- June manufacturing workweek was down 0.1 to 40.7 hours
- Factory overtime was up 0.1 to 3.3 hours
- The labor force participation rate was 62.7% versus 62.6% in May
- The uptick in the unemployment rate was a function of a slight expansion in the labor force participation rate.
- This followed a 0.2% decline in the participation rate and a 0.3% decline in the Unemployment rate in May.
- The downward revision to May nonfarm private payrolls resulted in the first negative reading for that series since 2010.
- Total outstanding consumer credit increased by $18.56 billion in May after increasing $13.40 billion in April. The consensus estimate for May was $15.70 billion.
- In the preceding 12-month period leading up to May, consumer credit had risen by an average of $18.58 billion.
- The growth in May was driven primarily by nonrevolving credit, which increased by $16.20 billion. Revolving credit increased by $2.30 billion.
- In May, consumer credit increased at a seasonally adjusted annual rate of 6.25%.
There is no economic data of note scheduled to be released on Monday. However, it is worth noting that China will release CPI and PPI reports for June on Saturday at 21:30 ET.
- S&P 500 +4.2% YTD
- Dow Jones +4.1% YTD
- Russell 2000 +3.6% YTD
- Nasdaq Composite -1.0% YTD
LSE/Deutsche Boerse: Tender offer prospects still bullish, sources say - MergerMarket
* Brexit puts synergy value in doubt – Deutsche Boerse shareholder
* HQ location unlikely to be resolved until merger reviews complete
* Parties comfortable with timetable, see close before end-June 2017
Sufficient numbers of Deutsche Boerse [ETR:DB1] shareholders are likely to tender into the proposed combination with the London Stock Exchange [NYSE:LSE] for the deal to proceed, said a source and a person familiar with the matter and an industry banker.
An undecided top-25 shareholder in both companies said his support for the Detusche Boerse shareholder vote will be less forthcoming than in the LSE vote, where his fund endorsed the deal. The prospect of Brexit puts the value of synergies in doubt, he said, though he also suggested the merged entity would be a “powerful organization” with “enormous value creation.”
As of today, 24.87% of Deutsche Boerse shareholders have tendered into the deal. The parties need to clear a 75% threshold to approve the merger.
Most shareholders are expected to decide closer to the 12 July tender deadline, the person said.
The deal parties have received positive feedback from discussions with investors and are confident about hitting the necessary threshold, said the person familiar. Previous recommendations by ISS and Glass Lewis in favor of the deal’s LSE vote should also bode well for the ongoing vote, he reasoned.
Domicile change?
LSE shareholders having approved the combination at last week’s Court Meeting and the Deutsche Boerse tender process being open together place a constraint on parties should they look to renegotiate the terms of the deal in response to Brexit, a second person familiar with the situation said.
Recent press reports have raised the prospect that the parties could renegotiate the merger agreement in response to German regulators’ calls for supervisory authority over the company. Terms currently envisage the merged entity being headquartered in London. Any resulting change in domicile would require shareholder approvals, the source familiar and the second person said.
The deal parties have no plans to amend the merger agreement in the near term, the source familiar said. He noted the deal is still many months away from closing.
There is flexibility to change deal terms including location following the close of the tender period, said the source familiar, though issues such as the headquarters location are not likely to be considered until the competition review process advances in the autumn.
The persons familiar agreed, calling speculation about a change of domicile premature.
Still, the shareholder said a change in HQ location should be made to a location within the EU. He argued that the Hessen Exchange Supervisory Authority’s likelihood of blocking the deal as high if the domicile did not change.
The shareholder and banker both downplayed the likelihood of a domicile outside of London, however. The banker was sceptical the nationalist forces that created Brexit would be a supportive background to UK regulators and politicians capitulating to a re-domicile of the country’s marquee exchange.
Timing
Regulatory scrutiny and potential concerns about domicile might impact how the deal closes, but not the timeline, the source familiar said. There is no reason to wait for UK-EU negotiations on Brexit to conclude before executing the deal, he said.
The parties still expect the deal to close ahead of the 30 June 2017 long-stop date, the source and first person familiar said. All jurisdictions should be able to clear the merger by 1Q17, the person and shareholder said.
With the long-stop date still almost a year away, the parties have more cushion than NYSE Euronext allowed in its blocked USD 17bn bid for Deutsche Boerse 2011-12, the source familiar reasoned. The termination date is not being extended as of now, he added.
While the shareholder also anticipated an early 1Q17 closing, he noted that he would certainly withdraw approval if the deal required a longer closing as late as 2018. Under the UK Takeover Code, the long-stop date can be extended “with the agreement of the parties to the offer”.
A longer extension would potentially exclude the parties from alternative value-enhancing initiatives, the banker said. For LSE, a post-Brexit tie-up with Intercontinental Exchange [NYSE:ICE] could become more attractive as both bourses may avoid European Union merger control scrutiny encountered by the current deal, he reasoned. The oft-speculated combination of Deutsche Boerse and CME Group [NASDAQ:CME] could likewise be given new air, he said.
LSE and Deutsche Boerse declined to comment for this article.
The Italian job
Italy’s teetering banks will be Europe’s next crisis
INVESTORS around the world are extraordinarily nervous. Yields on ten-year Treasuries fell to their lowest-ever level this week; buyers of 50-year Swiss government bonds are prepared to accept a negative yield. Some of the disquiet stems from Britain’s decision to hurl itself into the unknown. The pound, which hit a 31-year low against the dollar on July 6th, has yet to find a floor; several British commercial-property funds have suspended redemptions as the value of their assets tumbles. But the Brexit vote does not explain all the current unease. Another, potentially more dangerous, financial menace looms on the other side of the Channel—as Italy’s wobbly lenders teeter on the brink of a banking crisis.
Italy is Europe’s fourth-biggest economy and one of its weakest. Public debt stands at 135% of GDP; the adult employment rate is lower than in any EU country bar Greece. The economy has been moribund for years, suffocated by over-regulation and feeble productivity. Amid stagnation and deflation, Italy’s banks are in deep trouble, burdened by some €360 billion ($400 billion) of souring loans, the equivalent of a fifth of the country’s GDP. Collectively they have provisioned for only 45% of that amount. At best, Italy’s weak banks will throttle the country’s growth; at worst, some will go bust.
Not surprisingly, investors have fled. Shares in Italy’s biggest banks have fallen by as much as half since April, a sell-off that has intensified since the Brexit vote. The biggest immediate worry is the solvency of Monte dei Paschi di Siena, the world’s oldest bank. Several attempts to clean it up have failed: it is now worth just a tenth of its book value, and could well come up short in a stress test by the European Central Bank later this month (see article).
Size alone makes Italy’s bank mess dangerous. But it is also an exemplar of the euro area’s wider ills: the tension between rules made in Brussels and the exigencies of national politics; and the conflict between creditors and debtors. Both are the consequence of half-baked financial reforms. Handled badly, the Italian job could be the euro zone’s undoing.
Hang on lads, I’ve got a great idea
Italy urgently needs a big, bold bank clean-up. With private capital fleeing and an existing bank-backed rescue-fund largely used up, this will require an injection of government money. The problem is that this is politically all but impossible. New euro-zone rules say banks cannot be bailed out by the state unless their bondholders take losses first. The principle of “bailing in” creditors rather than sticking the bill to taxpayers is a good one. In most countries bank bonds are held by big institutional investors, who know the risks and can afford the loss. But in Italy, thanks in part to a quirk of the tax code, some €200 billion of bank bonds are held by retail investors. When a few small banks were patched up under the new rules in November, one retail bondholder committed suicide. It caused a political storm. Forcing ordinary Italians to take losses again would badly damage Matteo Renzi, the prime minister, dashing his hope of winning a referendum on constitutional reform in the autumn. Mr Renzi wants the rules to be applied flexibly.
But politics is also in play in the euro zone’s creditor countries. Germany rightly says that Italy’s troubles are largely of its own making. It has been unforgivably slow in getting to grips with its crippled banks, perhaps because its regional lenders are bound up in local politics. Any system that allows member states to pick and choose which rules to comply with is bound to unnerve voters in Germany. Just as Mr Renzi has a lot to gain from watering down or suspending the rules, clemency may have a political cost in Germany, where elections are due to be held next year. “We wrote the rules for the credit system,” said Angela Merkel, in response to Mr Renzi’s appeals for leniency. “We cannot change them every two years.”
If they planned this jam, they planned a way out
Nonetheless, the Italian prime minister is right. The market pressure on Italy’s banks will not ease until some confidence is restored, and that will not happen without public funds. If the bail-in rules are applied rigidly in Italy, the outcry from savers will both damage confidence and leave the door to power open for the Five Star Movement, a grouping that blames Italy’s economic troubles on the single currency. The feeling will grow that Italy is getting scant benefit from the supposed pooling of risks across the euro zone, but is damaged by the many constraints it is under—by its inability to devalue its way towards stronger growth, by a fiscal compact that shackles its budget, and now by bail-in rules that came in after other countries had bailed out their banks. If Italians were ever to lose faith in the euro, the single currency would not survive.
There is no point in following rules to the letter, if doing so leads to the demise of the single currency. So the correct response is to allow the Italian government to plump up the capital cushions of its vulnerable banks with enough public money to quell fears of a systemic crisis. Such a rescue should come with conditions: an overhaul of the Italian banking system that forces tiddlers to merge and slashes overheads by closing the country’s profusion of branches. To give the European bail-in directive a greater chance of being implemented in future, it should be changed so that retail investors who already hold bank bonds are explicitly shielded.
Some sort of fudge is more likely. There is already talk of a handy clause in the bail-in rule book that would allow a temporary capital injection for Monte dei Paschi. That may be enough to put a floor under stock prices so that Italy’s other banks, such as UniCredit, are able to raise private capital. Europe would doubtless hail such an outcome as an example of rules-based solidarity. But if history is any guide, it would neither return Italian banks to full health nor resolve any of the bloc’s underlying problems. One lesson of Brexit is that glossing over the concerns of voters is not a sustainable strategy. The euro zone’s jerry-built financial architecture does so twice over, by sidestepping the fears of those in creditor and debtor countries. That will not work for ever—which is why investors are right to be so worried.