After the action of the previous days one might reasonably think that we were due a quieter day yesterday. Well so much for reason! It turned out that Tuesday the 27th April was the day where contagion fears in the euro zone were fleshed out and started to become reality. The situation in Greece was already deteriorating and was sucking particularly Portugal into its tailwash when we saw the ratings agency Standard and Poors make an intervention. I was only explaining yesterday that equity markets often react to events like these with a delay of 3/4 months when the downgrade of Portugal and then Greece turned out to be a bit of a trigger for them and we saw heavy worldwide falls ( and perhaps moved with such a timetable again). As an aside I would like to point out the illogic of a downgrade from what should be a virtually discredited ratings agency being a trigger, and as one of the commentators on here has pointed out it is also analysis by the rear view mirror.
What did Standard and Poors actually do?
First it cut Portugal’s long-term rating to A- and its short-term rating to A-2 from A+ and A-1 respectively. The outlook is also negative. Also Standard and Poors give a quite damning assessment of Portugal’s position.
“Under our revised base case economic growth scenario, we expect the Portuguese government could struggle to stabilize its relatively high debt ratio over the outlook horizon until 2013. Portugal’s public finances in our view remain structurally weak, notwithstanding the government’s substantial public sector reforms of recent years.”
Then on what was clearly a day of action for them Standard and Poors downgraded Greece too by three notches.
We are lowering our ratings on Greece to ‘BB+/B’ from ‘BBB+/A-2′ and assigning a negative outlook. The negative outlook reflects the possibility of a further downgrade if the Greek government’s ability to implement its fiscal and structural reform program materially weakens in our view, undermined by domestic political opposition at home or by even weaker economic conditions than we currently assume.
In case you were wondering this is indeed junk status for Greece. Also it leaves the ratings agencies as like party guests who turn up just as you are clearing up afterwards.If they were schoolchildren I would suggest maybe 1000 lines, “I must be more pro-active in future”. I notice one or two suggestions starting to circle that they should be nationalised, my view on that is that the situation is already bad enough…..
A Serious Problem for the European Central Bank (ECB)
The downgrade for Greece immediately made me think of the ECB’s collateral rules. For those who are not regular readers I have written on the implications of these rules before particularly on the 29th March. But as a quick summary the ECB recently relaxed its rules to try to include Greece as from 2011 onwards it was looking likely that Greece would be excluded from the game.This is important because it is a system which provides plenty of profits for euro zone banks by allowing them to borrow at 1% from the ECB and depositing assets which have a higher yield, which has proved rather profitable for them to say the least for example for Greek banks it was worth around 3/4 billion euros last year. If you like this system has performed the role of moving economists theories of free money into reality.
The move by S&P took Greece below even the new relaxed (easy) framework. Now she still has a fingerhold because only one of the three ratings agencies have to give her a rating which allows her government bonds to qualify under the ECB’s collateral rules and there are two left (Fitch and Moodys). It will not be reassuring for Greek readers of this to see the next few words, ratings agencies tend to travel in packs.
The ECB has a terrible choice in this area and it is really quite simple does it wish to help Greece or does it wish to be a credible central bank? Sadly you can only relax your rules so many times. I also gave my views yesterday on the so-called nuclear option of the ECB buying euro zone members government debt in the comments section in a reply to Mr.Kowalski. The true reason that the ECB finds itself in this position is because of the dithering of the euro zones politicians and it would not surprise me if right now they were applying enormous pressure on the ECB to in effect to try and bail out the effects of their failures. In my view it must stand firm as you must think beyond the current panic and maelstrom to the follow on effects and implications of your actions.
I see that this morning that there has been another effort to blame speculators for this crisis.
The Hellenic Capital Market Commission, after taking into account the conditions prevailing in the Greek market has decided today to ban short selling of shares listed in the Athens Exchange. The ban becomes effective today 28 April 2010 and remains in force until 28 June 2010.
I wrote on this subject on the 16th April and since then I have not changed my views. If there are guilty parties in this they are three groups of people. There are those politicians who set up the Euro with a constitution which was badly flawed, there is a different group of European politicians who have dithered over the Greek crisis, and of course there is the previous Greek government which misrepresented her economic statistics. Markets are by no means perfect and sometimes they are not even rational and they do include “vultures” but in this crisis they are actually a force which is making politicians finally realise the implications and consequences of their errors and mistakes. The alternative would have been to continue with the mistakes which would if you think about it only have led to even bigger problems and an even bigger crash.
The World, European and Greek Banking Sector
As this crisis has been progressing I have been wondering more and more about the stability of the world’s banks and the impact of this crisis about them. The credit crunch led to in general terms the worlds governments (via their taxpayers) bailing out the worlds banks often in many ways that are not well understood (see my “free money” above) but as some governments hit trouble my thoughts turn back to the implications for the worlds banks. I have made a recommendation that a haircut of 20% (originally 15% but as things got worse…) should be applied to Greece’s government debt as part of my suggested repair mechanism for her current crisis. One of the reasons behind my trying to keep any haircut as low as possible is my fear for the Greek and also the European banking sector which could also hit the world banking sector. It is by no means impossible that even my level of haircut could make banks insolvent. Larger ones will virtually guarantee it in my view. I notice that as part of its report yesterday S&P had this in its report “indicating our expectation of “average” (30%-50%) recovery for debt holders in the event of a debt restructuring or payment default”. Such a move would drive banks insolvent and we would be in danger of going back to the collapse of Lehman Bros and all that implies.
I am grateful to one of my tutors at the LSE (Willem Buiter) for the chart in his report yesterday which gave some clues on this subject. The banks most exposed are French and they had an exposure of 79 billion euros at the end of 2009. This explains why the French authorities have been making rather gratuitous statements about the French government bond market being fine and her central bank governor stating that France had “relatively little” exposure to Greece. Well we now know what he means by relatively little and it begs the thought of what he thinks a large amount is. I was expecting German exposure to be higher than the 45 billion euros stated in the report so perhaps this is a contributing factor in their tougher line with Greece.
Rather disturbingly tucked down the list but with significant amounts we find Portugal with an exposure of 9.8 billion euros and Ireland with 8.6 billion euros. These are very significant for several reasons. One is that they are comparatively large when compared with their economies and of course it is not as if they do not already have problems od their own. In particular the Irish banking system has only just been bailed out and Bank of Ireland only announced details of its right issue plans this week. So clear problems and remember one of the lessons of what happened with Lehman Bros was that financial crises often have implications in unexpected places, what I was taught as “the serially uncorrelated error term”
This was in two camps as we saw government bond yield rise in the affected countries often quite substantially. Greece’s ten-year government bond yield closed at 9.54% but the real impact was felt in Portugal where her ten-year bonds now yield 5.61% and Ireland where her equivalent yields 5.25%. Comparing these with the German benchmark gives us +2.68% and +2.31% respectively.However German ten-year bund yields actually fell to 2.93% in what is called a flight to quality. As UK ten-year government bond yields also fell (to 3.95%) perhaps a better phrase is risk aversion!
How does this work?Having pointed out yesterday in my later update a flaw in the EU rescue plan I wish to repeat it for the benefit of earlier readers.
Portuguese three-year government bond yields have now risen above 5% partly because she has just been downgraded. The significance of this will not be lost on people who understand that she will be expected to provide funds to Greece at 5%……..
Germany might be able to subsidise Portugal’s position from her “windfall” but not if her Constitutional Court had anything to do with it.
The crisis is continuing and contagion may now not only be from country to country but I fear that it could hit banking systems too. As I wrote yesterday I believe that there is a brief window of hope still for countries such as Portugal if they were to take the advice I gave immediately, but time is now running very short. Markets do ebb and flow and they may be able to take decisive action and benefit from an ebbing. As to my wider thoughts on implications for the euro zone I am reminded of my conclusion on the 23rd February’
Of this there are two and they are the two polar extremes. The Euro zone can drive forward political and fiscal integration to put it into the position it should always have been or it can break up. It does not have to break up entirely as an inner core could remain. I believe that Europe’s politicians will drive for further integration but will fail. In essence I think that the German taxpayer will be unwilling to shoulder the implied burdens of it and as this crisis develops they will become clearer on what the costs will be.