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How heavenly is the German haven?

Angela Merkel stated last week: “Germany is strong. Germany is the economic engine and the anchor of stability in Europe. (...) But Germany’s strength is not infinite”. We could not agree more with the latter part.
Investment Strategy Group
Lombard Odier, June 21, 2012

Germany cannot support the Eurozone by itself without its debt burden rising explosively and trend growth falling as a consequence, or without bringing its precarious banks dangerously close to the brink of collapse. With EUR 17 trn of deposits and a total asset base of EUR 34 trn, the Eurozone banking system dwarfs the EUR 1.2 trn German tax base. When combined with their aggregated government debt, the assets of the top 10 Eurozone countries’ Monetary Financial Institutions are 35 times the German tax base (21 times including the French tax base). Germany is simply too small to save the Eurozone.

Yet, Germany is putting vast sums of money into the Eurozone rescue system, acting as if it can prevent the GIIPS countries (Greece, Ireland, Italy, Portugal, Spain) from defaulting. The upper chart shows Germany’s total claims within the Euro system as a percentage of its GDP. In April 2012, the country was exposed to the tune of 25% of its GDP, 8 times more than in 2007. According to the IFO institute, German losses via all European bail-out funds if the GIIPS countries were to default amount to EUR 704 bn. Whilst this would not bankrupt the country, this would imply a very worrying increase in Germany’s debt to GDP ratio.

So, why would Germany expose its own finances to such risk and pay for other countries’ fiscal irresponsibility? The German banking system is the most leveraged in the Western world, with a Tangible Assets to Tangible Common Equity ratio of 28 in April 2012, according to the latest IMF Global Financial Stability Report (middle chart). This compares to just 11 in the US. Moreover, German banks still hold USD 439 bn exposure to the GIIPS bloc, or 13% of Germany’s GDP (lower chart). Germany, by lending money to the peripheral countries, is trying to prevent its fragile and leveraged banks from getting hit, effectively orchestrating a backdoor recapitalization of its own banking system.

This is a dangerous bet. Germany is too small to save the GIIPS. When they default, Germany will not only take losses through its banking system exposure to the peripheral countries, but also through its commitments within the European bailout funds. We would avoid all investment in German banks exposure: waves of nationalization, recapitalization and big dilution lie ahead.

On the other hand, we expect the demand for Bunds to remain strong. With a current account surplus and inflows of deposits out of the periphery, the flow of new debt should face no financing difficulties in the near future, and yields stay accordingly low, still making Bunds one of the safest remaining assets, despite the caveats to German righteousness.

Link to the report