Euro Area Finance Ministers Meet Tomorrow: No Exit

The euro area finance ministers meet tomorrow.  Their discussion will be in sharp contrast to next week’s FOMC meeting.   The FOMC will ostensibly be talking about beginning to exit from the QE by slowing down the pace of its asset purchases.  Surveys suggest a majority expect the Fed to announce the a tapering of its asset purchases.

Although the existential element to the European crisis has most certainly eased, significant challenges remain.  It is more likely that official sector has to do more before it can even contemplate an exit and this will be increasingly clear in the coming weeks.
Reports suggest the ECB has discussed a new long-term repo operation (LTRO).  Of course, some banks have paid back their previous ECB borrowing and this is serving to shrink the ECB’s balance sheet and reduce the excess liquidity in the system that has kept the key overnight rates near zero.  The suggestion of the possibility of another LTRO, like Outright Market Transactions (OMT) program, may have a desirable effect, easing the need for action.
Yet is seems LTRO early repayments, which have amounted to about 40% of total sums borrowed, reflect the emergence of a two-tier banking system.  Smaller and weaker banks still need that financing and a new two-year LTRO would in effect extend the current LTRO.  With the current LTRO maturing in Dec 2014 and Fed 2015, the decision is most likely not imminent, but 1) cannot be ruled out and 2) is not simply a function of macro economic data. 
Existing aid programs for Greece and Cyprus will be discussed.  It seems clear that Greece has a funding gap that needs to be addressed.  Yet, officials have limited scope to reduce debt servicing costs through lower interest rates and longer maturities.  Unlikely to be agreed now, but the risk is that a package that does not quite cover the anticipated gap is agreed upon, to retain the carrot of additional debt relief when Greece achieves a primary budget surplus.
There seems to be a consensus among officials that the Cyprus program is on track.  That means there are no obstacles to the disbursement of aid tranche at the end of the month.
A Troika mission is headed for Portugal next week.  Government efforts to fill its own shortfall have run into judicial resistance.   There is some concern that Portugal, like Ireland, may need some assistance in an orderly exit from the aid programs.  A standby facility, like the “flexible credit line” of the IMF (which was granted to Mexico, Colombia and Poland, but not tapped) may be helpful, but given some of the push back against the IMF’s concentration of European exposure, this function could be filled by the ESM.
Meanwhile, the ECB continues to wage a quiet campaign for ESM assistance for Slovenia.   This will also be discussed at the Eurogroup meeting tomorrow.  Recall that during and after the Cyprus crisis, many identified Slovenia as the next likely candidate for assistance.  Although it has been pushed off the front burners, it has been simmering in the background.  In April, we had identified the problem as serious but not urgent.  The urgency is increasing.
Last week, Slovenia announced it would liquidate two small private banks (Factor Bank and Probanka) and would guarantee 1.3 bln euros of the banks’ liabilities.  This raises two other issues.  First, these two institutions account for only about 4.5% of the country’s banking assets and 1.3 bln guarantee is about 3.7% of GDP.  The OECD estimates the non-performing loan problem could be a fifth of GDP.
Second, the Slovenian government aid to the two banks seems to go against the direction that the euro area is moving.  Specifically, reports indicate that the aid is aimed at protecting all but the subordinated debt holders.  Under the agreement that was reached earlier this year, senior unsecured lenders also must be “bailed in” before taxpayer money is committed.

This piece is cross-posted from Marc to Market with permission.