Five Overlooked Euro Zone Developments

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There are several developments that warn of future problems in the euro zone and these make us suspicious about the euro's ability to sustain the upside break.

First, we are surprised by the lack of commentary and focus on an important ECB decision last week. It decided to give member central banks the option of not accepting bonds as collateral under written (guaranteed) by countries receiving international assistance. The ECB was explicit, national central banks are not obliged to accept bank bonds guaranteed by such sovereigns. Recall that in early January the ECB allowed 7 of the 17 national central banks to accept a broader range of collateral. This may not seem to be significant at the moment, but if there is a new flare up of tensions, this could compound the challenge of the distressed countries' banks.

Second, and not totally unrelated, borrowings from the ECB require collateral and there is increasing concern that the banks may be asked to pony up more collateral. The line item on the ECB's balance sheet where this can be monitored is "credits related to margin calls". This exploded in December 2011, but has moderated each month here in the first quarter. The risk is on the upside here.

At the same time, there is some concern that a rising share of European bank asset are already spoken for (encumbered in the jargon). The more assets are encumbered (used as collateral) the fewer assets are available in a recovery situation for unsecured creditors. This becomes another form of subordination. This may keep the cost of unsecured funding high even though the risk of default, judging from the indicative pricing in the CDS market, has eased.

Third, when trying to assess a member's budget position, often ignored are the unpaid bills. The data is not easily available and when it is available, there are often long lags. Looking at Spain, for example, unpaid bills amounted 72.9 bln euros in Q3 '11 and 87.5 bln euros when trade credits are included. This compares with 50 bln in unpaid bills in 2005 (including trade credits) and 68.5 bln euros on the eve of the crisis (2007).

Fourth, bank deposits, excluding government and financial institutions (essentially individual and non-financial corp deposits) are falling in some countries. The January data showed Greece suffering the largest fall (17.6% year-over-year), followed by Ireland (-6.1%) and Spain (-2.8%) and then Italy (-1.9%).

Leaving aside tiny Malta, France has seen the largest increase in such deposits (10%) followed by Finland (8.3%). Of note Finland's deposit growth peaked last September and has been slowing every month since then. France's deposit growth accelerated in January to its fastest pace since May 2008, fully recovering from the slowing seen late last year.

Fifth, while Portugal's deposits in January 2012 were 3.2% higher than in January 2011, there has been significant fiscal deterioration. Tax revenues fell 5.3% in the Jan-Feb period, while the social security expenses, which include unemployment benefits rose 8.1%. This resulted in a core public deficit of almost 800 mln euros vs 274 mln for the same year ago period. Part of the deterioration reflects the repayment of debt by the state broadcaster RTP.

The euro has broken above the $1.33 area for the first time since it broke beneath there at the start of the month. The upper end of the wider range is seen near $1.35. The euro has not traded above $1.35 since early last December. While some observers attribute the euro's advance to Bernanke's comments which they interpret as dovish, we note that the debt market thinks differently as US 5-10 year yields are rising 4-7 bp today. The euro dollar futures strip from May through next March imply a 1 bp lower in yield.

While the dollar is heavy, the euro's gains against the greenback also seem to reflect cross rate demand against the yen, with euro re-taking the JPY110 area. That said, on other crosses, like the Australian and Canadian dollars, and Scandi's, the euro is losing ground.