The Economic Observer: Where are we now in terms of the development of the debt crisis?
Paul Donovan: The banking issue is separate from the sovereign issue in some regards. That is to say, a number of Euro-area banks have had specific problems with capitalization. They are under capitalized and have become extremely dependent upon the wholesale market for their financing needs which has created a series of problems.
We have another problem that is related, but is a different problem which is the sovereign debt problem. What that problem reflects is a concern about the level of debt, the level of deficit and the need to refinance existing debt and roll over existing debt, as well as refinancing deficits in an environment where no government can print its own money.
The Economic Observer: Talking about the stress test, we just interviewed the Spanish central bank; they are merging Caja. Do you think their measures are sufficient to calm the market now?
Paul Donovan: No. I do not I'm afraid. Merging a group of weak institutions together does not solve the capital problem. This just creates a large weak institution rather than a small weak institution. We saw this in the past with Japan. That is exactly what Japan did in the early 1990s. It does not work. The banks need new injection of capital. They need to raise money. Now there is an attempt by the Spanish government to inject some capital into the banking system, but unfortunately we believe it does not go far enough and additional capital will be required over and above what the government has currently committed to in Spain.
The Economic Observer: What should the Spanish government do to ensure the market of the stability of their banks?
Paul Donovan: Large banks do not have a particular problem. It is the local banks that are the problem. The Spanish government needs to effectively recapitalize these banks and get them to a situation where they are not dependent on the European central bank for short term funding needs.
The Economic Observer: Where will the money come from in your speculation?
Paul Donovan: This of course is the critical problem. This is the difficulty. It will have to come from the Spanish government. It is extremely unlikely that the private sector will recapitalize the banks. At the least they might be prepared to recapitalize a small proportion, but not the full amount that is required.
The Economic Observer: You think there is a serious risk there and that Cajas problems will deteriorate as a result of the stress test. Is that true?
Paul Donovan: No. Well nobody really knows what will be going into the stress test. They have not said. They have not said which banks it is going to cover; I think it is likely that the Caja will be included. If they are included I think there will be questions about how strict the stress test is. I would suggest that what is going to happen is that the European Authorities will decide what the results of the stress test are going to be and then they will adjust the stress test to achieve those results. So if the Spanish authorities want them recapitalized aggressively then they will simply set the stress test at a level which will require it. If they have however decided that they do not want to recapitalize the Caja aggressively then they will simply insist that the stress test is not that aggressive and the results will achieve an appearance of stability as far as the Caja is concerned.
The Economic Observer: What will happen when the twelve month LTRO expires?
Paul Donovan: There was a concern in some quarters that the withdrawal of liquidity would be a problem. The ECB has actually not withdrawn liquidity at all. The ECB has for several quarters provided unlimited liquidity to the market. The ECB today is still providing unlimited liquidity. What has changed is during the duration of that liquidity, the ECB was providing unlimited liquidity for twelve months, now it is providing unlimited liquidity for three months. All that is currently happening is a change in the duration of liquidity. This does not cause me too much concern.
The Economic Observer: Another important ECB decision has been buying bonds directly from the market. Recently China has been looking a lot to the European bonds market; what do you think about this interesting change?
Paul Donovan: The ECB does not have a great deal of choice, as the ECB has decided that it is appropriate to increase liquidity into the system, the ECB has limited options available to it. If the ECB wishes to be aggressive it basically has two mechanisms available to it, the refi operations or the direct purchase of bonds on the secondary market. So if you start from the assumption that we must have an increase in liquidity supply as liquidity demand has gone up, liquidity must rise. Starting from that perspective there was not a huge amount of choice for the ECB. They could have done more in terms of refi operations and money market, but that is at the risk of creating distortions in the economy. They need to use as many different options that they can to achieve their objective.
The Economic Observer: Do you see any link between the Asian investors on the ECB purchase of bonds here.
Paul Donovan: I do not think there is a direct concern and I do not the believe that the ECB is concerned about Asian investors one way or another.
The Economic Observer: The stress tests in the US were a turning point for the financial turmoil there. As you said the conclusion has been set by policy makers. What do you expect this conclusion to be?
Paul Donovan: I think that there are significant differences with the United States. The US stress tests were about bank recapitalization. There were two things. First, there was a bank capitalization problem which needed to be resolved but secondly, the government was there to facilitate, help with the recapitalization and the markets were able, or the markets and governments between them, were able to recapitalize the banks.
In Europe, there is a capitalization problem, but there is also a funding problem; the reliance on the wholesale market as a form of funding. The governments are less able to recapitalize in the Euro area than they are in the United States and they are not able to address the wholesale funding problem at all. That means that the stress tests produce somewhat different reactions in the European case than they do in the US case. I would not suggest that the US tests were perfect. I do not think that they were. Nevertheless, the outcome in the states was a recapitalized banking system. They raised capital regardless of the results of the stress test. I do not see that happening to the same extent in Europe. That is something that causes me some concern.
The Economic Observer: Are you saying transparency of the stress test is currently very low?
Paul Donovan: At this stage it is, but then the European government never promised to publish the criteria in advance. They might publish the criteria next week, they might not. Nobody knows. Currently there is a lot of discussion and rumours about what the criteria are. But we haven’t had a definitive conclusion at this point.
The Economic Observer: So you are saying that unless the transparency of the test results has been increased, even if there are good results after the stress test, they will not boost the market very much?
Paul Donovan: I would not expect it, no. It is one of those things that if you have a mid-level result, not too good and not too bad, that might boost the market because people would think that there was something reasonably credible about the test even if they do not have all of the information available. It is an uncertain position.
The Economic Observer: I think some of he experts including the ones we have interviewed are saying that the sovereignty issue is more important than the liquidity problem. Do you agree with that?
Paul Donovan: Yes, I would say so. The two problems are linked. But I think that the sovereign crisis is a little more important. The sovereign crisis will take longer. A liquidity problem by very nature is an immediate, very sudden problem; the solvency crisis of sovereign debt rarely is a very quick crisis, it is something that evolves over a period of some years.
The Economic Observer: Do you mean something like a whole restructuring of the economy?
Paul Donovan: There are issues of restructuring the economy, restructuring debt. And more than just restructuring say the Greek or German economy. There is also the necessity of restructuring the euro. The euro does not work. As a single currency, economically, it is a bad idea. So, on a five year view, we need to consider restructuring the institutions of the EU, not the membership, but how the euro works. Effectively, what we need is a fiscal union in Europe.
The Economic Observer: What should be done to reform the eurozone? Which areas should be the focus of the reform?
Paul Donovan: The only way that the euro will work economically is to introduce a fiscal union with fiscal transfers which is to say there is some kind of central system protecting and spending. It does not have to be a government. You can have a confederation that does this, but if there is not a way of making sure that central fiscal policy taxes growing areas and spends in weak areas, then the euro is going to be extremely negatively affected.
The advantage of a fiscal union is that you are not talking about Germany bailing out Greece. You are talking about strong parts of the economy bailing out weak parts of the economy. For example, if there was a fiscal union in Europe, east Germany would benefit, west Germany would pay; northern France would pay, southern France would benefit. Greece would probably benefit across the board, but you are not talking about countries bailing each other out, you are talking about regions. Just as New York is bailing out California; New York is paying taxes to Washington, Washington is paying unemployment benefits to California. That is the position that you need to get to in the euro area.
The Economic Observer: But do you think the European people are ready for that kind of unified identity of Europe?
Paul Donovan: Not now, no. But they are going to have to be. But, no question, they are not ready at the moment.
For example the stability fund is already a step toward a fiscal union. It is a small step, a very small step, but we are moving that way and on a five year view say, I think we could be a lot closer to a fiscal confederation or a fiscal union. On a five year view, if you have a series of crises, in that five year period, at each crisis, Europe will move another step forward. Europe is very good at integrating divided areas during a crisis. So basically what I’m saying is that the euro area will have a lot of crisis over the next few years and that will help the euro area to change.
The Economic Observer: What are your thoughts on the problems affecting the banking industry?
Paul Donovan: Well, I think in a very general sense, one of the big concerns is that regulation it is not coordinated globally. What this is doing is raising the cost of capital, so globally, it is going to be more expensive to borrow money. Over the next ten years, the world needs to invest more than it have ever done in the past. But environmental considerations, water resources, energy efficiency, all of this means that we need to invest in infrastructure in countries like China, like America, like the UK and Europe. The bank regulation environment and the uncoordinated bank regulation environment is raising the cost of capital, at the same time, the world is increasing its demand for capital, and this is going to be one of the biggest challenges the world economy is going to have to face up to the next ten years.
The Economic Observer: Especially for China. We need the capital in the next few years, right?
Paul Donovan: I'm sure I do not need to tell you, but the water problems in China are huge. And it will be a major concern, particularly as the Three Gorges Dam has not been as successful as hoped in terms of irrigation. There needs to be major investment in infrastructure as China continues to grow as an economy. But it is the same in Europe. A gas fired power station built fifteen years ago would be 35% efficient. 35% of the energy in gas would be converted into electricity. Now, a gas fired power station is 60% efficient. So you have nearly doubled the energy efficiency of electricity generation. What that means is that the gas fired power station you built fifteen years ago is already out of date and it needs to be upgraded; it needs to be replaced. And that means more investment and continues to be the challenge we face up to.
The Economic Observer: What will be the overall growth rate of the EU?
Paul Donovan: Well, as we are looking ahead, I think it is hard to see Europe growing much above its trend rate of growth over the next couple of years and for us, trend growth in euro area is about 1.7%. So as we look ahead over the next couple of years, I think Europe, this year and next year will come in at about that level. Now that does not sound too bad, but bear in mind that Europe is supposed to be in a recovery. In a recovery, Europe is supposed to grow at about 3.5%. That is what is normal, you are supposed to grow at double the trend rate of growth in the first couple of years of recovery. To be growing at around trend growth is a very weak recovery for the euro zone. Now that is a global issue as well. The United States are in the same sort of position.
The Economic Observer: Will the weaker euro last? Will it be kept low and will export benefits last?
Paul Donovan: Well, bear in mind, that the euro today is not necessarily at an exchange rate that we would classify as weak. It is weaker than it has been in the recent past, and I think the euro will actually weaken further over the next couple of years. We would be forecasting a euro-dollar of 1.10 and the end of 2011, so we do think that the euro may weaken a bit further. So the situation is, it is better that the currency is weaker than stronger, but it is not a strong benefit in this domestic market.
