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Why Germany's Banks Need the ECB's Lifeline

Germany's banks have sent the country's trade surplus back whence it came...

THE MUCH anticipated additional liquidity boost from the European Central Bank (ECB) came merely within expectations. Yesterday the ECB revealed that an amazing 800 banks had come sniffing around for a bit of cheap money. Nearly  €530 billion as it happens, writes Greg Canavan for the Daily Reckoning Australia.

And according to the Financial Times, many of the banks were German. This goes to show the absurdity of the Eurozone structure.

Germany, we are told, is a nation of savers. Fiscally prudent types who keep their houses in order. That's why the nation runs a trade and current account surplus.

But where do all these savings go? Into the banks mostly. And the banks send these surplus Euros back to the European periphery to finance the trade and current account deficits run by countries like Greece, Spain and Portugal. It's a classic vendor financing scheme...along the same lines as China and the US.

There are two sides to everything in economics. If Germany has a current account surplus, it has a capital account deficit. Everything must balance. So while German citizens might feel individually prudent, the custodians of their money – the German banks – have been fiscally imprudent.

They recycled the money from the trade surplus back to the countries that borrowed to buy in the first place. And they kept lending German savings to countries with deteriorating credit profiles. Now they're largely insolvent and need central bank handouts.

While banks are partly to blame, they're simply operating within a flawed economic structure. Because Germany is so much more competitive than southern Europe, for years it has generated excessively large trade surpluses. To keep the game going, Germany has recycled these surpluses back to their customers. They are lending their customers money to buy their goods.

Normally, currency and interest rate changes would rectify the imbalances. Lower interest rates and a stronger currency in Germany versus higher interest rates and a weaker currency in the deficit countries.

But that can't happen in a currency union. The irony is that for years the Eurozone based monetary policy on Germany's economic growth needs. Low interest rates helped drag Germany out of its post-reunification slump.

But interest rates were held far too low for the peripheral countries. It created a credit boom, excess spending by households and governments – and it certainly didn't provide the incentives required to increase competitiveness.

While Germany was getting its house in order with monetary assistance, southern Europe was in party mode. Now, Germany has no intention of returning the favor. It won't accept inflation domestically as a method to correct the imbalances within the Eurozone. Instead, it wants to impose deflation on the periphery.

The ECB is now pitching in by perpetuating a broken system. The banks all know they're broke so they don't want to lend to each other. So the ECB fulfills that role. It gives the banks 1 per cent money in return for any old collateral (meaning bank assets that no one else wants to hold as security) and hopes the banks will in turn lend to cash-strapped sovereigns at around 5 per cent.

The interest rate differential makes it a sweet deal for the banks. On the surface, it's three years of very, very, easy money.

But this whole can- kicking exercise is based on the expectation that economic growth will save indebted governments.

The simple math of debt dynamics says that for a country's debt-to-GDP profile to improve, its economic growth rate (plus or minus the primary budget balance) must be greater than the market interest rate it's paying on its debt.

Take Italy for example. It has a debt-to-GDP ratio of 120 per cent. Its economy will contract this year by at least 0.5 per cent (and probably more) while the budget deficit will come in over 1.5 per cent. With interest rates on the 10-year bond still 5.2 per cent (that's after the ECB's double bazooka effort), the math says that Italy's debt-to-GDP ratio grows by 7.2 per cent this year.

And it will probably grow again in 2013. There won't be much improvement by 2014/5 (when this latest ECB liquidity experiment expires) so we'll be back to square one.

The market knows this. It won't take three years to start attacking Italy's bond market again. It may do so in another two years...or maybe less, six months.

But it will happen. It there's one thing 'the market' instinctively attacks, it's an inefficiency...a flawed structure. It will wait until the time is right...and then all hell will break loose.

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Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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