Yesterday saw a little break in the number that I have been following, as we did not see an extension of the recent trend which had seen up to that point 22 of the last 28 days have a triple digit closing move in the American Dow Jones Industrial Average equity index. However we did see it rally around 120 points in the morning and then it close some 40 points down, so the wide intra-day swings that we have had to get used to have continued. So this remains a difficult scenario for the private investor, in my view. For today’s article I wish to look at some of the features of the euro zone crisis and not all of them are what you might expect.
Portugal’s bond issue
Yesterday Portugal issued some new government bonds. This was a test of the Securities Market Programme which the European Central Bank has so far announced has been backed with 40.5 billion Euros of its cash. If you are a central bank buying up bonds then you would hope that a bond issue would go well. What happened was that Portugal paid an interest rate of 5.225 % to raise 816 million Euros in 10-year bonds.If we look at the previous ten-year bond issue on May 12th then the interest rate paid is 0.7% higher , as the average yield was 4.523 % on that date. In addition Portugal also sold 701 million Euros of three-year debt and these bonds which mature in September 2013 were issued at an average yield of 3.597 %, this is up considerably from the 1.715 % of two months ago.
If you look at a bond issue in difficult times then the first point to make is that the issue was got away and all bonds were sold. However if we think of Portugal’s situation she had to offer yields 0.7% and 1.88% higher than the previous respective issues so there was a painful cost for her. At the end of this year her ratio of national debt to Gross Domestic Product is expected to rise to 85%. If we take the average of the two yield rises above then we get approximately 1.25%. Putting them together gives an annual interest rate cost of 1.06% of Portugal’s GDP if she had to renew all her debt on these terms. Now that is an extreme example as it would take quite a while for this to happen but it does give an idea of the issue and of course this effect will be travelling in the reverse direction to her austerity plan.
Another issue was that the yield Portugal had to pay for her ten-year bonds was higher than some expect to be charged by the newly created European Financial Stability Facility which is the new name for the Special Purpose Vehicle or SPV (perhaps there were other Captain Scarlet fans….). Portugal has confirmed that she has no current plans to tap such money. But the fact that events forced her to make such an announcement is an embarrassment for the ECB’s government bond buying programme. The apparent plan to reduce the scale of bond purchases each week is not going well and needs to be reversed.
Staying in the Iberian peninsula there was a report in the Spanish newspaper Cinco Dais that Spanish banks are having trouble getting funding in the inter-bank markets. Whilst middle ranking Spanish banks were up until recently having to pay a premium in such markets now “no foreign entity in the interbank market is funding us.” An unspecified President from a caja or savings bank is quoted as saying that they are having to rely more and more on funding from the ECB and that “we can not give credit to our customers.”
There are plainly issues with Spain and her banking sector. I do not know if they are as bad as the newspaper suggests. However there is one area I have been personally following. You see I am a football fan and the Primera Ligua has some quality teams. Furthermore the main two Barcelona and Real Madrid have the reputation of being able to be big spenders because the local/regional government backs them. You might think with central government cutting back that so might the football clubs. Instead we have Barcelona purchasing the striker David Villa for around £35 million and Real Madrid supposedly paying Jose Mourinho £10 million a year to be its new manager. My point is that this sits rather oddly with austerity doesn’t it? I welcome other thoughts on this issue.
Switzerland and Currency Intervention
In the recent melee which has surrounded the Euro and its recent falls against other currencies there has been a nation indirectly affected quite badly and it is Switzerland. It is a side-effect of the euro zone crisis but is also becoming something of an economics test case. As money flees the euro zone and the Euro it looks for somewhere to go and Switzerland has a reputation not only for economic stability but stability all round and so money has gone into the Swiss Franc. The problem with this is that Switzerland is only a small country and there is a limit to this implied in her size. However the flood of money that entered Switzerland in the earlier part of 2010 caused the exchange rate between the Euro and the Swiss Franc to drop from 1.51 in mid-December to 1.4325 at the end of April. In an attempt to halt this rise the Swiss National Bank tried currency intervention to stop this move and for example in March 2010 it bought some 16 billion Euros. The problem is that it expands their money supply and their M2 measure began to grow quite quickly. In essence the scale of the problem looked like it might overwhelm them.
What happened next?
The Swiss National Bank tried even harder. There was rumour after rumour that she was intervening to support the Euro and limit the rise of the Swiss Franc. In April she intervened on a scale estimated at 1 billion Euros a day and in May she intervened on an enormous scale as her foreign exchange reserves rose from 151 billion Swiss Francs to 232 billion which is an increase of just over 50% in one month according to the provisional figures she has released. Did she succeed? Well the exchange rate as I type is 1.379 versus the Euro so the attempt to hold 1.40 as a level failed.
Comment and implications
I have often thought that currency intervention against long or even medium term pressure on a currency is likely to be pointless and it is the Swiss National Bank’s misfortune to have pretty much established a test case proving my point. I do have some sympathy for their strategy however as they have been faced with a very difficult situation and having started on a road of currency intervention then “one more push” must have seemed tempting. Just to add to the fears of the Swiss National Bank I did see a report which opined that an exchange rate of 1.25 to the Euro would put Switzerland (all other things being equal) in deflation. Economics text books often have a chapter on the implications of being a small open economy and Switzerland is facing a sub-section of many text books right now.
There are further implications of this.
1. Although the underlying Swiss economy has remained strong there must be a contractionary effect on her exporters such as Roche,Nestle and Novartis.
2. Her measures of money supply will be under considerable strain from this because of its scale and it will require a lot of effort to sterilise the intervention.
3. Moving outside of Switzerland a lot of property and construction borrowing in Eastern Europe was denominated in Swiss Francs. It is not a good situation for these borrowers to see the flip side of the Swiss Franc appreciation ie. their debt has risen in their own currency. Quite what the regulators were doing in these countries to allow mortgages etc. to be denominated in this way escapes me… However it is not a surprise to me that we have seen signs of economic distress recently in Bulgaria and Hungary for this reason.
4. Switzerland simply cannot sustain this level of foreign currency intervention (15% of GDP in one month) so we will see soon what happens when she stops. The SNB must curse the recent report from UBS that suggests the Swiss Franc could be a replacement for the Deutschemark!
5. If you attempt to value the losses that the Swiss National Bank has made with this programme you come to around 6 billion Euros at current levels.
6. Diapson Commodities have tried to value the effect of all this intervention and come up with the following. If you assume that all Swiss exports have a perfectly elastic demand curve and that there are no gains to be had from the commensurately cheaper imports foregone then, with Swiss goods exports to the Euro zone running at around Swiss Franc 35 billion for the period (together with perhaps another Sfr12 billion in service exports) then the intervention might at best have staved off Sfr4.2 billion in lost export revenues (9% of SFr47 billion as this is the difference between the appreciation of the Swiss Franc and the US dollar) – for each single franc of which lavish act of sectional corporate welfare no less than SFr32.80 have been printed up and passed out, with all the risks this entails for future monetary stability. Ouch.
There does not appear to be a way out for Switzerland via currency intervention. She can hardly try much harder. Those with memories back to the 1970s or with a sense of history will remember that in this time period Switzerland tried negative interest rates for foreigners as a policy measure and even added capital controls. Unfortunately even such measures failed to stop the Swiss Franc appreciating. Such are the problems of being a small open economy with a floating exchange rate.
In the end she may have to choose between price stability and her exchange rate but again this has been tried (1978-81) and the Swiss did not like the inflation it produced. The best I think that they can do is to slow the appreciation of the Swiss Franc and hope for the world economic situation to improve. At least they are starting from a position of relative economic strength, those who in Eastern Europe borrowed in Swiss Francs have a larger problem and they may yet transfer it to those who lent them the money.