It’s clear that the European Central Bank (ECB) wants to exhaust all options before it resorts to out-and-out quantitative easing (QE).
It has cut interest rates to a record low of 0.5% – and now it is even talking about making interest rates negative, which would mean banks being charged to hold money at the ECB. The idea is that this would encourage them to lend it to businesses instead.
However, we think it’s only a matter of time before Brussels is forced to take action.
And the country that will force its hand is the one that is more opposed to money printing than any other – Germany…
Germany is heading for stagnation
One reason why Germany might give way on quantitative easing is because its own economy has been feeling the pain as its fellow eurozone nations slow down.
This might not seem obvious at first glance. The most recent German data suggests that the economy is in reasonable shape, and the stock market is certainly cheerful. In March, industrial production rose by 1.2% on last year, instead of falling as everyone had expected – the news sent the DAX index to a record high.
But if you break the data down into its constituent parts, then this increase looks less impressive. A large part of the rise was due to energy, where production rose by 4%; in contrast, consumer goods production rose by only 1%, while construction fell by 3.1%.
As Ben May of Capital Economics points out, it’s also important to put the recent figures in context. The falls seen in recent months have been so large that even after the recent rise, production is still 2.6% lower than at the same time last year.
And even if Germany does manage to avoid a technical recession, growth is unlikely to be very strong: even Berlin thinks growth will only come in at 0.5% this year. That would increase the pressure on Angela Merkel to allow more money printing.
Meanwhile, German’s ‘northern bloc’ allies – the other countries who agree with its hard-line stance on budget cuts – are running intro trouble. Holland, for example, with its heavily-indebted private sector, has now fallen into a recession. And this is only deepening - if you adjust the latest Dutch production figures for seasonal changes, production is falling by over 5%, while the unemployment rate jumped from 7.7% to 8.1% in the last month alone.
The truth about German banking
However, there is a much more pressing reason why Berlin may be forced to agree to another round of QE.
The problem is perhaps best summed up by Deutsche Bank, Germany’s largest private financial institution.
One reason why the financial crisis hit banks so hard was the amount of leverage that they took on. This meant that even a small, temporary fall in the value of their underlying assets meant that they were effectively bust – hence the bail-outs and the rush by central banks to buy assets.
Since then, regulators have been trying to increase the amount of capital that banks hold. In theory, this should mean that they are better able to withstand losses from bad investments, reducing the risk of them going bust, or needing a bail-out.
However, this may not be the full story. There are concerns that some banks are up to their old tricks. Instead of directly loading up on debt, they are concealing their borrowings through complicated derivative contracts.
Tim Bennett explains what derivatives are, and how you can use them to your advantage.
Now, the banks themselves argue that this shouldn’t be a problem. They point out that a lot of their derivatives are hedged. This means that if the value of one contract falls, another will automatically rise, cancelling out any loss.
In effect, they’ve taken out insurance that reduces most of the risk.
However, there are two flaws with this comforting notion. Firstly, it assumes that the banks have an accurate picture of their position. This is not always easy with such complicated, opaque instruments.
There’s also the question of what’s known as ‘counterparty risk’. In simple terms, it means that if there’s a sudden market movement, then banks may find that the people they bought the contracts from can’t afford to honour them. It’s a bit like finding that your insurer is bankrupt.
While this is a problem for all banks, it is particularly extreme for Deutsche Bank. According to Niels Jensen of Absolute Return Partners, its gross derivatives exposure is the largest in the world at over €55trn. (For perspective, German GDP is under €3trn).
This means that if we saw a serious banking crisis – triggered by Italy or Spain leaving the euro, say – then much of the European banking sector would be in a lot of trouble. And it goes without saying that if Deutsche Bank did have to be bailed out, the costs would blow a hole in Berlin’s finances.
Indeed, the problems are so bad that officials have floated the idea of breaking up the banks into smaller units. While all banks would be covered by these rules, its hard to not to see this as an attempt to rein in Deutsche Bank.
This means that, despite growing demands to get even tougher with the southern countries, Germany will have to agree to more money printing at some point in the near future. They simply can’t push the southern nations to breaking point. Because if one of these countries goes to the wall, the eurozone banking sector will explode.
That’s a scary prospect. But we’ve already seen what happens when central banks step in to flood the system with money. It’s very good for stocks. And that’s why you should look at buying into the cheaper eurozone markets just now to take advantage. As we’ve mentioned several times in the past , we particularly like Italy, which you can buy via the iShares FTSE MIB exchange-traded fund (LSE: IMIB).
• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .
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