Thursday, June 28, 2012

Europe: Insolvent or a Liquidity Problem?

The case is being increasingly made, by many commentators, that Europe isn't in need of cash (liquidity), but that it is technically insolvent.

Now having a liquidity crisis in any organisation is defined in Wikipaedia as: "refer(ing) to drying up of liquidity, which could reflect a fall in asset prices below their long run fundamental price; or deterioration in external financing conditions; or a reduction in the number of market participants or simply difficulty in trading assets. To be illiquid nmeans you may not have enough ready assets to convert into cash quickly."

Insolvency, on the other hand, is defined in Wikipaedia as: "the inability of a debtor to pay their debt. Cash flow insolvency involves a lack of liquidity to pay debts as they fall due. Balance sheet insolvency involves having negative net assets—where liabilities exceed assets."

So you can see that Europe very much falls into the insolvent league of organisations. Banks do not have enough liquid assets, or the means to produce them, to convert into cash to pay their liabilities. They are bust.

Sure, the central banks of the world could coordinate a huge injection of new money to take these bad assets/debts out of bank balance sheets. But this would only be an 'extend and pretend' mechanism that would not solve the underlying issue of low growth coupled with too much spending.

But don't just give Europe a hard time. In New Zealand here, the Government has just restructured our national railway company and revised asset valuations on it's books. These new valuations have decreased the size of the railway company by $1.1 billion; and increased our national debt by the same.

It makes you wonder how much more of a problem would the banking system be if assets, currently on their books, were a marked to market value and not to whatever nefarious valuation the banks have given them. Valuations that suit the banks solvency position. A bit like an ostrich hiding his head in the sand or the 'hear no evil, see no evil, speak no evil' scenario.

All rather a muddle really.
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