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Monday, September 27, 2010

And Then There Were None

According to Spanish Prime Minister José Luis Rodríguez Zapatero speaking in an interview with the Wall Street Journal last Tuesday the European sovereign debt crisis is over. "I believe that the debt crisis affecting Spain, and the euro zone in general, has passed," Mr. Zapatero said.

This is excellent news, but it comes with just one proviso, and that is that despite all such reassurances most financial market participants seem to be far from convinced that he is right. True Spain recently raised nearly €4bn in a successful government bond sale, with some observers suggesting the sale constituted but one more sign that what is still the eurozone’s fourth-largest economy had finally broken free from the group of “peripheral” European economies who have severe economic problems and whose debt is viewed by investors as especially risky.

In fact Spain managed to sell €2.7bn of 10-year bonds and almost €1.3bn of 30-year bonds while at the same time bringing yields down noticeably from their earlier highs - to 4.144 percent in the case of the 10-year issue ( from 4.864 percent in June), and to 5.077 percent for the 30 year issue (from 5.908 percent in June). But, at the same time, in the background the extra yield that investors demand to hold Spanish 10-year bonds over German bunds has been steadily creeping back up again, and as of last Friday (24 September) it stood at 183 basis points, below the 220 level being asked in June but still more than double what it was at this point last year.

Yet, despite all those nice words we hear from him, one of the things that is worrying investors right now is the real depth of Mr Zapatero’s commitment to reducing the deficit as planned, especially after he unexpectedly stated on August 10 that in his opinion some of the planned infrastructure spending cuts could be reversed, while on September 10 he reiterated the point, saying that lower borrowing costs may enable the government to "ease up" on some of the projected spending cuts. In fact the extra yield offered on Spanish debt has risen 33 basis points over the period since he started to mention the possibility.

On top of which all the short term indicators we have been seeing suggest that the Spanish economy started to contract again in the third quarter.

Spreads Rising Across The Periphery

Of course it isn't only Spanish bond yields which have been sneaking back up of late. Greek 10-year bonds as compared with equivalent German bunds still offer around 950 basis points (or 9.5 percent) of additional yield, only around 20 points below the all time record they hit on May 7, at the height of the Sovereign Debt Crisis

Indeed spreads on government bonds all along Europe's periphery have been rising steadily back towards (and even in some cases beyond) their May levels in recent weeks. Most notably the last week has seen both the Irish and Portuguese government 10-year bond yields surge to euro era records levels, in a way which could lead us to ask whether, rather than Spain snuggling back into the main group the big picture story at this point might not be that it is Irish and Portuguese sovereign debt that is being prised apart from the rest.

So rather than being over, what the debt crisis now may be entering is a new stage, where one sovereign bond after another is being chisled out and sent off to join their Greek counterpart in the isolation ward. Actually, in this sense the present European Sovereign Debt situation does rather resemble the plot of the well known Agatha Christie detective novel "And Then There Were None". As told by M. Christie a group of ten people, all of whom have in one way or another been previously complicit in an earlier death, are somehow tricked into travelling together for what was intended to be a short stay on a secluded island. Once there, and even though the guests are apparently the only people on the island, they are - somehow, and one after another - systematically murdered. So, in a way which may eventually come to foreshadow scenes from the forthcoming meetings of the European Financial Stability Facility management board, each morning one guest less shows up for breakfast. One by one, and little by little, each participant becomes mysteriously overcome by a seemingly inexplicable bout of some fatal variant of what could be termed "systemic instability syndrome".

As I say, Irish and Portuguese yield spreads are significantly wider than they were May 7, the last trading day before Greece finally agreed to go for their €110 billion bailout package and the European Central Bank announced the initiation of its ongoing program of purchasing EuroArea government bonds in the secondary markets.

And despite holding what was considered to be a "succesful" bond auction at the start of last week Irish 10-year bond yields, shot up`once more during the remainder of the week, hitting a new record high of 6.34 per cent (see Bloomberg chart below), while yield spreads over benchmark 10 year German Bunds spiked to 416bp, euro era another record. At the same time Ireland 5 year CDS shot up to 461 bps, which meant the cost of insuring Irish debt was $461,000 for $10m of debt annually over five years.

At the same time yields on Portuguese 10-year bonds over comparable German bonds hit a record of near 4.25 percentage points Friday, while the Portuguese debt agency paid a euro era record of 6.24 percent to holders of its 10-year bonds and 4.69 per cent to holders of the four year-bonds in its own bond auction this week. In last equivalent auction, Portugal had paid 5.32 percent on 10-year bonds and 3.62 percent on four-year bonds. Portugal’s budget gap widened in the first eight months of the year, indicating the government may struggle to rein in the euro-region’s fourth-largest deficit as its borrowing costs surged to a record.

Portugal and Ireland "Decoupling"?

In each case the issue is different, since in the Irish case it was a sharp and unexpected contraction in the economy which became the major concern while in Portugal's case it was an apparent inability to reach the political agreement necessary to get the budget deficit under control.

Data out during the week for second-quarter gross domestic product showed the Irish economy has never really left recession, since GDP contracted by 1.2% compared to the first three months of the year, following a downwardly revised 2.2% expansion in the first quarter. Irish GDP has now contracted on a quarterly basis for 9 out of the past 10 quarters, and there is no evident end in sight.

In addition Ireland’s central bank governor Patrick Honohan saw fit to give a rather ill-timed press conference (unless he objective really was to force the country's government into the arms of the EFSF) where he urged the government to implement even deeper fiscal cuts to restore balance to the budget in what seems at this point to be a virtually unrealisable bid to regain investor confidence. All of which left many observers wondering just what the country can do in the present situation, since the budget is evidently deteriorating due to the severity of the economic contraction, and further cuts in spending by anyone (households, companies, government) are only likely to feed the contraction even more, in their turn making even more cuts necessary.

Obviously Ireland is rapidly approaching a situation where it cannot move the situation forward based on its own resources. This feeling is only added to by the persistent rumours that subordinated bond holders to Anglo Irish bank may well not get re-imbursed in full. These rumours have found some confirmation in a report which appeared in the Irish Examiner suggesting that the Irish Finance Minister Brian Lenihan had given a strong hint that the riskiest lenders to nationalized Anglo Irish Bank may not get all their money back.

Mr Lenihan apparently explained to the paper that the bank guarantee program which will be extended once it runs out at the end of September may only cover deposits and not subordinated debt. And if the interpretation put on events by the FTs John Dizard's is correct Mr Lenihan's delay in clarifying the situation is due to the fact that the Irish government is awaiting an EU Commission ruling on exactly this issue. His most recent official statement on the topic was that the Aglo Irish wind-up plan “is being prepared for submission to the [European] Commission for approval”.

At the same time the EU’s Competition Commissioner, Joaquin Almunia, issued a statement that “a number of important aspects need to be clarified, and a new notification received, before the Commission is in a position to finalise its assessment and to take a decision”. Which Dizard interprets as meaning that while Anglo Irish might propose a buy-back of its subordinated bonds, and that buy-back might be included in an Irish government proposal, Brussels might, in the end, not approve the plan. Since this would effectively the first time in the current crisis that a significant group of investors did not have their losses underwritten (apart, of course, from the rather unfortunate Lehman incident), decision makers may be rather apprehensive, since no one really knows how the financial markets would react. Yet speculation some such decision will be taken remains rife, as witnessed by the decision by Moody's rating agency to downgrade Allied Irish ratings. Moody's cut Anglo Irish's senior bonds by three notches to Baa3, the last level before junk, but the markets' main focus was on the deep, six-notch cut in the bank's subordinated debt, to Caa1, which indicates that bondholders will be forced to pay for some of the expected bailout.

Deficit Worries In Portugal

In the Portuguese case it is the budget deficit issue which is unsettling the markets, with the spread widening sharply following the revelation that far from the deficit being reduced is was actually increasing. According to the latest data from the Finance Ministry the central government’s shortfall during the first eight months of the year rose to 9.19 billion euros from 8.74 billion euros over the equivalent period in 2009. Previously the 2010 deficit had been almost exactly tracking the 2009 one (see chart from Societe Generale below).

Portugal’s borrowing costs surged to record levels on the news, and while the spread subsequently eased back to 388 basis points, the level is still close to the zone in which Greek bonds were trading in April just before the EU offered the country emergency loans to avoid default (see Greek 10 year spread chart below).

What this means is that this year's overall public deficit could well come in at around 9 percent of gross domestic product unless there is a radical change in policy during the last few months of the year.

According to its commitments to the EU Stability Programme, the Portuguese government should be aiming to reduce the overall deficit to 7.3 percent of GDP in 2010 from last year’s 9.3 percent. The government has pledged to reach the target, with Finance Minister Fernando Teixeira dos Santos saying that the country “can’t afford” not to, but so far there is little evidence that it will be able to do so, and especially with all the political bickering that is now going on in the background.

In all these cases, including the Greek and Spanish ones, this issue is not simply one of stimulus versus austerity (always a false polarity when it comes to the situation on the Euro periphery). The real issue is how to restore growth to highly-indebted and structurally-distorted economies, since without growth the debt to GDP ratios will not come down, and the burden of the debt will not be reduced.

So more borrowing is not what these countries need right now (other than to aid short term liquidity). What the countries involved all need is more exports and larger industrial sectors, and no one seems to be very clear how they are to achieve them. Simply running a double digit deficit to generate less that 1% (in the best of cases) GDP growth is not exactly a "wise" use of resources. Evidently using deficit spending to cushion programmes which would lead to a surge in exports would make sense, but in no case is this really being done, and all the emphasis is simply going on what may turn out to be a rather fruitless and self-defeating programme of achieving fiscal rectitude.

The result is that the peripheral countries are one by one being steadily "decoupled", with Portugal and Ireland now moving up towards Greece, as the following two charts from Citi Research clearly show.

For quite a long time the Irish and Portuguese spreads simply moved in harmony with the Greek ones, widening as the Greek spread surged upwards. But now it is Greek debt which can be adversly affected by sentiment over the situation in Ireland or Portugal, and not the other way round, and meanwhile the other two countries slowly but surely are moving on up there to join their Greek counterparts as the second of the two charts (which show the recent relative movements in Greek and Irish spreads) seems to demonstrate.

Vigourous Action Needed

Naturally the ongoing deterioration in the situation requires bold and far reaching action from the Commission and the ECB. Obviously we should expect to see renewed activity on the part of the ECB, buying an increasing number of eurozone periphery government bonds. Their activity on this front has been increasing of late, but weekly bond purchases are still well below 1 billion euros a week level seen at the height of the crisis in May and June. Evidently we will see calls for more of these purchases in the days and weeks to come, but what is striking at the present time is just how ineffective they have been in containing the damage.

The ECB’s bond buying program is effectively the second pillar in the EU crisis containment mechanism established in May. The other one is the Luxembourg-based 440 billion-euro European Financial Stability Facility, headed by former European Commission official Klaus Regling. Mr Regling has also been actively campaigning to calm markets in recent days. "It would be preferable if we didn't even have to intervene," he told the German magazine Der Spiegel in an interview, "In fact, I believe that's the most likely scenario." His hope then is that the very existence of his organization will bring calm to investors and deter speculators. "If that's the case, we'll close up shop here on June 30, 2013," he said.

Morgan Stanley’s Chief Global Economist, Joachim Fels remains pretty unconvinced by all of this. “Strains,” he wrote in a recent research report, have now reached a point where "one or several governments" may soon have to resort to the rescue mechanism. "Neither the European sovereign debt crisis nor the banking sector crisis has been resolved and both continue to mutually reinforce each other," he said, adding that the EU's stress tests for banks had manifestly failed to restore the necessary confidence. Fels's conjecture didn't need that long to get some confirmation, since according to the German newspaper Handelsblatt the ECB was last week actively considering recommending that Ireland avail itself of the fund. The Central Bank declined to comment on the story, and simply pointed out that any decision on the matter was a question for national governments, which is formally correct (and obvious) but doesn't mean that they wouldn't in fact have recommended such a move if asked.

So, like former US Treasury Secretary Hank Paulson before them, Europe’s leaders, having armed their bazooka may soon need to fire it. Indeed Mr Regling’s optimism that his organization may quietly disappear from the scene is not generally shared by investors, who as we are seeing seem to be continuously pricing in an ever greater likelihood of intervention.

Meantime, according to a report in the Financial Times over the weekend, Europe's leaders are once more at odds among themselves about just how much carrot and how much stick the various national governments need to get their economies back into line. Predictably it is Paris talking about carrots, and Berlin who is talking about sticks.

But all this talk of what to do about those countries who in the future fail to stick to the new set of rules which are apparently being prepared monumentally misses the point: what we need are some policies which help the most affected economies get out of the mess they have found themselves in following the way the monetary and fiscal policy rules were implemented last time round.

According to one popular analogy currently circulating , the EuroArea countries could be likened to a group of 16 Alpine climbers scaling the Matterhorn who find themselves tightly roped together in appalling weather conditions. One of the climbers - Greece – has lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding him dangling there, however uncomfortable it may be for them, but they cannot quite manage to pull their colleague back up again. So, as the day advances, others, wearied by all the effort required, start themselves to slide. First it is Ireland who moves closest to the edge, getting nearer and nearer to the abysss with each passing moment. And just behind Ireland comes Portugal, while some way further back Spain lies Spain, busily consoling itself that it is in no way as badly off as the others who have already lost there footing. But if Spain cannot hold out, and all four finally go over, each dragged down by the weight of those who preceded them, then this will leave some 12 countries supporting four, something that the May bailout package only anticipated as a worst-case scenario. In the event that this is finally what happens, Mr Reglin will certainly find that the quiet life has come to an end for him, and that he has plenty of work to do, as will Mr Trichet’s successor at the ECB. In the meantime all the rest of us can do is wait and hope, firm in the knowledge that having come this far, we can only go forward, since there is no easy way back down to the point from which we started. But for heavens sake, the only thing we don't need while we sit here biting our nails is to be told by someone who manifestly has no idea what he is talking about that the danger has already past, even as we slide, inch by inch, onwards and downwards towards the chasm that gapes beneath.

Wednesday, September 1, 2010

The Odd Couple

The modern world moves at a breathtaking pace, even when most of us find ourselves on holiday. No sooner do we receive, read and start to digest one set of economic data than we find ourselves pushed to think about what the next set will look like. The clearest recent illustration of this undoubted reality is to be found in peculiar twist of events which meant that just as the news reached us that the German economy had expanded at a record rate in the second quarter, at almost the very same moment Federal Reserve officials meeting in Washington decided to significantly downgrade their economic outlook for the United States, saying the “pace of recovery in output and employment had slowed in recent months” and was likely to be “more modest” than anticipated in the near term. But this followed a month of May when it seemed Europe's economies were on the brink of disaster, while over in the United States some sort of recovery was on the cards.

So what is going on here, does the earth switch it’s magnetic pole every six months, with what went up last time round now going down? Or could it possibly be some kind of common thread here, one common factor which unites the unprecedented expansion we have just seen in Germany, and the fears of renewed recession in the United States. Well, as it happens, indeed there could, and it has a name - the Greek debt crisis.

Structural Problems In The Currency Architecture?

So what is the link? Well, the fact of the matter is that we live in a bi-polar world, at least as far as currencies are concerned. Until our current global financial architecture evolves into something more sophistocated, we have two main currencies which rival one another for pride of place in central bank reserves and investment portfolios: the euro and the dollar, and when one of these goes up, the other must come down, and vice versa. It is as simple, and as complicated, as that.

Prior to February, and the outbreak of the European Sovereign Debt Crisis the US economy was seen as the weaker partner, and the euro was priced at a relatively high level. Then the euro slumped (falling at one point from around 135 to 120 to the US dollar in a matter of weeks) as attention focused on what appeared to be significant weaknesses in the Eurozone infrastructure. As a result of the change German exports boomed, while the US economic recovery steadily started to grind to a halt.

And with the rise of the dollar the global economy started to fall back into dangerous - pre crisis – habits. The US trade deficit started to open up again, and one exporting nation after another started to see yet one more time the US market as the global economy's consumer of last resort. Indeed the US June trade statistics reveal the extent to which American consumers are once more sucking in large quantities of imports as their spending power recovers, while weak demand in the rest of the world coupled with the comparatively high dollar has been keeping a brake on American exports.

As the New York Times put it in an editorial, "China is mopping up demand everywhere you look with its artificially cheap supply of goods, while Germany, the world’s other exporting power, is cutting its budget and relying on foreign demand to drive its economic rebound. This isn’t sustainable".

And the numbers prove the point. The United States trade deficit ballooned to $49.9 billion in June, the biggest since October 2008. In July, one month later, China recorded a $28.7 billion trade surplus, the biggest since January 2009. In the first five months of the year, Germany’s trade surplus, driven in large part by demand for machine tools in recovering Asian economies (many of them busily sending exports to the US), rose 30 percent compared with 2009.

And this impression is only confirmed when we come to look at the latest revision for US GDP in the second quarter. According to the revised data, US GDP increased at an annualised 1.6% rate (as compared with the 9% annual rate in Germany), after registering a 3.7% rate in the first quarter, according to the Bureau of Economic Analysis (BEA) today. The second-quarter growth rate was revised down by 0.8 percentage point from the “advance” estimate (of 2.4%), in part as a result of the new data on imports for June. The US Bureau of Economic Analysis report stated that slower GDP growth primarily reflected a surge in imports compared with the previous quarter and a slowdown in inventory investment. In fact, real exports of goods and services increased at a 9.1% rate in the second quarter, compared with an increase of 11.4% in the first, while real imports of goods and services increased by 32.4%, compared with an increase of 11.2% in Q1.

Effectively the American economy is simply too weak to carry this additional load, and is now showing signs of heading back towards recession, forcing the Federal reserve, which only a few months ago was moving towards a tightening in monetary policy to fend off inflation to now re-assert its policy of quantitative easing to avoid any posssibility of a drift towards deflation.

Meanwhile the German economy turns in a 2.2 per cent quarterly growth spurt, unified Germany’s best-ever performance. The annualised 9 per cent growth rate, is, as the Financial Times noted, virtually unprecedented in developed economy terms. Such dramatic changes, rather than reassuring us that all is well, only lead to even more doubts. Is it really desireable for an economy to shoot forward so dramatically, only to fall back again in the second half, which is what almost everyone (Monsieur Trichet included) expects to happen?

Not only does the German performance seem exaggeratedly large, at the other end, on Europe's periphery, the result was lamentably small. Greece naturally exceeded everyone's expectations, on the downside, with a 1.5 per cent quarterly contraction (a 6 per cent annual rate), but Spain remained at the bottom end of the range, with a 0.2 per cent expansion, as did Portugal. Undoubtedly the Greek contraction will slow as the year advances, but the outlook there continues to be preoccupying. Only today the Greek manufacturing PMI, which showed the contraction in Greece's industrial sector accelerated again in August, has reminded us of just how difficult it is going to be for the country to return to growth, and especially if the external environment now starts to deteriorate.

As the FT's David Oakley said yesterday, in many ways Germany could be said to have had a "good crisis", since the Greek issue pushed the Euro down and German exports up, while the current flight to safety is driving down the yield on German bunds to record lows even as it pushes up the spreads for peripheral Europe sovereigns. Among other imapcts this gives German companies an even greater competitive advantage as their capital costs come down even while those for their competitors go up.

Spreads – which are the additional borrowing premiums countries have to pay over benchmark Bunds – hit a fresh record of 357 basis points in Ireland this week, following problems in Allied Irish bank and a Standard & Poor's downgrade. In Portugal and Spain, spreads have been creeping back up, and are now once more close to their all-time highs. Spain’s 10-year bonds are trading at about 192 basis points above Germany, compared with 57 at the start of the year while Portugal is trading at 333 basis points, compared with 67 on January 1. The following chart shows how peripheral spreads have evolved since the start of the year (they have been indexed to 1st January). As is evident they shot up in May, then came down to lower levels in July, but during August they have once more been climbing.

All three economies are experiencing extremely weak growth and Ireland is even flirting with deflation. Higher government borrowing costs can harm economies in a number of ways, from higher borrowing costs for companies to added pressure on a country’s public finances as more is eaten up in interest charges, leaving less for public services and stimulus. Effectively the presence of a large spread differential means that monetary policy is applied unevenly across the Euro Area, despite the "one size for all" objective of the ECB. And doubly so with a credit crunch which means some banks struggle to finance as a backdrop.

Japan Trapped On The Ropes

And as if all of this wasn't enough, Germany's main competitor in Asia (where German exports have been clocking up large increases) has been effectively KO'd by the flight to safety produced by the Sovereign Debt Crisis. Japan's exchange rate against the USD dollar is now hovering around a 15 year high.

The consequence of this is not hard to predict, while Germany clocks up record exports to China and other parts of the continent, the Japanese "recovery" is gradually grinding to a halt, as the latest manufacturing PMI report only confirms.

We Need To Seriously Address The Imbalances

At the end of the day it is hard to avoid the conclusion that we continue to live in a very unbalanced and essentially economically unstable world, where currency valuations and economic growth rates fluctuate with unnerving rapidity. Not only that, the recent Federal Reserve meeting seems to have constituted some sort of defining moment, the point when everyone finally recognises that the long promised recovery was no longer simply weeks or months away, and that emerging from the trough in which the developed economies find themselves is going to involve a long period of slow and painful effort, one where we will also need time to clean up the mess we have made in cleaning up the original mess, assuming that is that we have the dynamism and energy to do so.

On thing is clear, the old habits won't work any better now than they did before 2007, and external deficits which were not sustainable then will not be sustainable now. So we need a new model, a model in which the emerging markets will have a much larger role to play than ever before. And if we are to move towards a more sustainable future, then we need to move beyond those simplistic headlines stressing the virile nature of Germany's export prowess. There is no doubting the efficacy and competitiveness of many German companies, but for that very reason that country needs to shoulder more of the responsibility for sharing the burden which is involved in finding solutions. Here in Europe we don't only need sacrifices in the South, some of them also need to be made in the north. German industry is enjoying real and tangible benefits (via artificially low interest rates and an undervalued currency) from the mess that the Greeks created for themselves, but in the interest of all European some of those benefits need to be plowed back in again, since if Greece is allowed to fail, no one will be the winner.

Looking beyond Europe we need to think about how to best aid and abet the emerging economies in their quest for growth and better living standards. Earlier in the crisis I asked Nobel Economist Paul Krugman a question which is very much to the point. “At a time when the financial crisis is generalised across all developed economies - whether because those who borrowed the money now have difficulty paying back, or those who leant it now struggle to recover the money owed them - to which new planet are we all going to export?”

My response to him back in January was that maybe we don't need to look so far afield. Many developing economies badly need cheap and responsible credit lines, and access to state-of-the-art technologies, so why not accept the world is changing, and go for some sort of New Marshall Plan, one capable of generating a win-win dynamic which would be in all our interests? At the time the proposal seemed totally unrealistic and unobtainable. Now, with every day which passes it starts to look essential. And who knows, maybe the rise of a number of other major economic powers would help solve that bipolar currency problem which is currently causing our policymakers so many headaches.