After reviewing the recent aid package for Greece announced by the euro zone on Sunday in my articles on Monday and Tuesday it became clear to me that it was a short-term palliative rather than a cure for Greece’s problems which are much longer term. It would appear that yesterday world markets came to a not dissimilar conclusion as we saw quite a bit of nervousness and risk aversion which led to considerable market movement. Quite what the euro zone’s leaders made of this as their grand project to help Greece appeared to actually make things worse for her is hard to say. As they have behaved somewhat irrationally and erratically during this crisis they are hard to figure out. However as the situation developed (and spread to Spain) then the Spanish Prime Minister Jose Zapatero called the speculation “complete madness.” You may not be surprised to hear that his statement was followed by further stock declines. It is like they inhabit another universe which has an alternate reality.
I like always to make positive suggestions and here is one. If the leaders of or anyone influential in Spain or Portugal are reading this I suggest you take a look at what Ireland has done. I wrote on this subject on the 2nd April and I concluded that her early decisive austerity package was well received by the markets and that there was a reward for virtue.
I am pleased to report that there has been a reward for virtue from the financial markets if you compare Ireland with Greece. That is not the message many (politicians in trouble) want to hear.
I believe that this is still true and that a dose of such medicine would help both Spain and Portugal. Indeed I recommended this for Portugal on the 27th April in my analysis of her situation. There is talk of her taking action but she badly needs action and not talk. Time is running very short.
What actually happened yesterday?
When markets become unsettled and nervous usually they are swept with rumours, well yesterdays was that Spain had asked the IMF for an aid package of either 240 or 280 billion Euros. I did not particularly believe it for two reasons. The first is that it would not be enough, the second is that the IMF would not lend that much in my opinion. So there is a blatant flaw there…. but these types of rumours are more examples of psychology rather than cold hard facts which are often somewhat weak.
The first impact was on bond yields. Here there was more distress for Greece with her ten-year government bond yield closing at 9.79% which is +6.82% over the German ten-year bund, and her three-year government bond yield rose to 16.48%. I put that in to suggests that the four German professors who are going to the German Constitutional Court might have an easy job as it makes a subsidy of 11.48% by my maths. If we look at short- term Greek government bonds we should be seeing falls in yields because of the changes in ECB collateral rules yet two-year bond yields have surged nearly 5% since I was typing yesterday to around 14.5%. I wish to just reinforce this message as it is important, we have bankers turning down what is a very easy carry trade,this is not what bankers do unless they are afraid perhaps very afraid. They are patently afraid of Greece defaulting to my mind.
Spain Ireland and Portugal
We saw rises in ten-year government bond yields for these countries too. Portugal saw a rise to 5.75%, Ireland saw a rise to 5.3% and Spain rose to 4.12%. The spreads over Germany’s equivalent rose to +2.78%, +2.33% and +1.15% respectively. Stock markets fell with Portugal falling by 4.21% Spain falling by 5.41%, and the Athens composite index fell by 6.68%.
You might wonder what caused the Spanish Prime Minister to speak and also probably encourage the IMF to come out and deny there was any aid package planned for Spain as her circumstances are a lot better than her near neighbour Portugal. Inspite of all the failures of this tactic it would appear that at least one politician feels that talk and hyperbole is still an effective weapon.
What I think is really beginning to worry people about Spain is that her banking system may be hitting trouble. I have written over the past few days about problems in the interbank markets as banks are beginning to refuse to deal with other banks which they feel have too much exposure to Greece. Well these sort of rumours are now spreading to the state of Spain’s banks. Why might this be? One factor is that Spain’s banks particularly the local cajas are suffering from quite a lot of non performing loans due mostly to the state of her property market and the fact that she now has a 20% unemployment rate. My understanding is that the Spanish housing market remains under pressure on the back of a persistent supply overhang. There was plenty of borrowing by Spain’s private-sector to help finance this property boom and according to Standard and Poors her level of private-sector indebtedness is 178% of her Gross Domestic Product.
So she is in better shape than Greece for now but if you project her current situation forward she has no great plans to reduce her fiscal deficit and her economy looks like it will struggle to grow. Not an inspiring combination. Last year her fiscal deficit rose by some 7 percentage points compared with the year before to 11.2% so it is showing signs of getting out of control. However her national debt is much lower than Greece’s. So the real issue for now appears to be Spain’s banking sector. Also she now has to raise 9.8 billion Euros to help Greece.
The IMF and Primacy
I returned to this subject on the 16th April as I feel it is an important issue.
1.Primacy. Who is in charge? Will it be the European Commission? the European Central Bank? the IMF? If you wished to set-up something which was unwieldy and inflexible this is exactly how to do it. The IMF does sometimes co-operate with other institutions but it is used to having primacy and control.
As you can see I was troubled by the prospect of the IMF not being in charge.Well is it? Take a look again at the statement on Monday from the ECB.
The Greek government has approved an economic and financial adjustment programme, which has been negotiated with the European Commission, in liaison with the ECB, and the International Monetary Fund.
So that’s a no then…
Flights to safety
At times like this you get investors looking for what are considered to be safe assets. So one would expect the yields on US Treasury bonds and German bunds to fall and they did. If you look at their ten-year government bonds they both fell by around 0.1% in yield terms. I mention this because in a way this is also a measure of contagion risk as it is a measure of risk aversion and hence that basic human emotion fear.
It is also true that UK government bond yields fell and so there was a perceived flight to quality here too.Markets are not always fully rational when there is fear about and in a sense the rally in UK government bonds only two days before an election that is very much in the balance can be seen as another way of measuring how much fear is about. You see to my mind markets can often be quite irrational when they are afraid.
Also one or two economists seem to be coming to the opinion that the agreement over Greece means that Germany will now be forced to bail out the rest of Europe if necessary and in effect is underwriting their debt. I think that this is the wrong conclusion.
I would like to return to Greece and her aid package and look at it.
The fatal flaw in it was its failure to have any plan for debt restructuring in it. Without it then it is simply not a plan to return Greece to solvency.
Another issue is how exactly will Greece put herself in a position to repay these loans? There is no real answer to this so the begged question that is forming in people’s minds is what will the replacement aid package look like?
Even a bank bailout on this scale has not prevented fears for other banking systems such as Spain’s.
The fall in the Euro’s exchange rate is likely to be welcomed. However think of the second order effect. The biggest beneficiary is likely to be Germany’s exporters and so we get economic divergence again which is where this crisis came in. Supporters of the Euro project still in my mind do not have any answer at all to this problem.
Please remember that markets ebb and flow but that the fundamental issues here do not.
I have written before on the subject of governments issuing short-term paper. I feel that it is an area which is most revealing of perceived prospects for an economy as whilst governments and central banks do not fully control these instruments they do in normal times have “influence” over this end of the yield curve.
Today Portugal has issued 500 million Euros of 6 month Treasury Bills at an average yield of 2.96%. The last time she did this the yield was 0.74% and as recently as the 27th April the yield on a similar bill was 1.83%. I think the numbers speak for themselves.