After discussing China’s situation yesterday in terms of her plans for reserve requirements and her inflation problems it would appear that events have taken a further step forward this morning. The financial world is awash with rumours that China is on the verge of raising her interest rates and the Chinese Shanghai Composite Equity index has fallen by 5.2% in response to these rumours and the knock-on effects are being felt around the world. The Japanese Nikkei 225 fell by 136 to 9724 and European equity markets opened very weakly although the FTSE 100 has now recovered to be only 1.1% down. It is also true that the lack of any real progress at the G-20 meeting may have influenced markets although I doubt much was expected as the differences between the countries present was and is simply too great.
I have written before about the dangers of what Brazil’s finance minister called “currency wars” which in the worst case could lead to the type of competitive devaluations that contributed to the economic crises of the 1930s. The response of the G-20 in its statement can be summarised as follows.
“Uneven growth and widening imbalances are fueling the temptation to diverge from global solutions into uncoordinated actions……….Uncoordinated policy actions will only lead to worse outcomes for all.
This is an odd statement because for example the United States has been following a policy of tacit US dollar devaluation since this summer, Japan has been trying to devalue her currency since she began intervening on September 15th, and of course the Chinese have been running an undervalued currency for some years. These are precisely the sort of uncoordinated policy actions the statement talks about so I can only presume the leaders will return home and resume doing what they have just criticised! It is a bit like their attitude to global warming where they criticise other behaviour but then are happy themselves to travel around the world to meeting which usually achieve little.
One possible gain from the meeting is that it will allow EU leaders to sit down out of the glare of publicity and discuss the rapidly developing crisis which is threatening to engulf Ireland and Portugal.
The Crisis in the Euro Zone
If we step back for a moment and consider the implications for the Euro and the institutions that support it then we can see that this stage of the crisis is beginning to pose fundamental questions for it and them. When the Greece crisis reached its peak in late spring it was possible for the EU to get together the funds it felt it required to deal with the situation, I wouldn’t say without problems but Greece is only a small part of economic output for the area as a whole and so the scale of the rescue was relatively small. Now the Euro zone is facing having to do the same for Ireland and Portugal. Whilst in terms of relative economic size these are again relatively minor players it is only 6 months or so after the Greek debacle that we are seeing real contagion with 2 more sovereign states in trouble.
The problem that we immediately hit is that the two solutions to the problem that the Euro zone came up with are flawed.Back in May measures were instituted in a panic which were not thought through. They may have been an answer to the political crisis allowing politicians to proclaim victory and display hubris but this type of short-term solution only kicked the can 6 months down the road. So the dose of Euro fudge was initially sweet but has turned out to have sickly after-effects
The Securities Markets Programme
The Securities Markets Programme where the European Central Bank buys debt in the countries which have “disequilibrium” has spent around 64 billion Euros since it was invented in early May.The problem is that it was no real objective and is if you like a programme which responds to panic in markets.Accordingly it has been unable to get ahead of events and spends its time chasing the markets tail. Unfortunately if you think about it you see a situation where it must have two problems, firstly it has accumulated losses as virtually every purchase in Ireland and Portugal must be loss-making at this time, and secondly it has built up a balance sheet of what are considered to be assets of low credit value. So the SMP is revealed as a programme which poses dangers to the ECB’s balance sheet, and is therefore potentially a problem for Europe’s taxpayers. Also it has led to divisions within the ECB itself. If we go back to early May the ECB had a meeting where it claimed it did not even discuss this subject then four days later it found itself corralled into it by Euro zone politicians. One effect of this was to split the ECB into two camps as some are still critical of the SMP which hardly increases credibility.
The European Financial Stability Facility
This is perhaps the most flawed institution of all. I serious wonder if it will even work if it is called on and it will at best be slow and unwieldy. I suspect under the hype and hyperbole Europe’s politician’s genuinely believed that the announcement would be enough and that it would never need to be actually deployed.
The first flaw is that it is a bilateral agreement between the 16 Euro zone nations. This means that those in need of aid drop out of providing funds. Then we see that countries in effect have to raise their own share of the funds with the EFSF doing that for them and to achieve a AAA credit rating it holds back some 20% of its theoretical funds. So by my maths of the 440 billion Euro’s hyped we are now down to around 336 billion. Next we hit the fact that the bonds which need to be issued will by definition be done at a time of crisis, what if markets are unwilling to in effect lend to countries on the terms suggested? Let me give you two examples where they might say no, Spain and Italy. So the funds might shrink again. Also if you think of timing all this will take time when an urgent response is likely to be needed and could go on and on. Just to put the icing on the cake some now think that for it to work it would have to raise the interest-rate it charges from the originally anticipated level which was around 5.25%.
There has been speculation by Wolfgang Munchau that the interest rate charged could be 8%. Should he be correct then the solution to sovereign nations having long-term interest rates which make them insolvent is to charge them an interest-rate which makes them insolvent! Should he turn out to be correct this may be an entry in the most incompetently designed international agreement.
Personally I do not feel that it will charge 8% and will remain around 5 to 5.5%% but the size will be much smaller as it will in effect rely on what Germany and the core Euro zone countries are willing to raise. So I would suggest that the size might turn-out to be more like 200 billion Euros. Of course this relies on these nations being willing to do this as their politician’s may find that their voters are much less enthusiastic about the implications of this.
Ireland and her deepening crisis
The impact of this crisis has hit Ireland and her government bond yields hard. Her ten-year government bond yield closed last night at 8.8% and even her bond which expires in January 2014 now yields over 8%.Ouch.Through the crisis I have argued that her shortest dated bond is significant as it has a year to go and it now yields 5.68%. It is significant because the ECB official interest rate is 1% and it is the gap between the two or 4.68% that matters. Whilst the ECB will not officially give you money at 1% for a year does anybody really think that if it was contacted by a buyer of Irish bonds that it would say no? Some deal would be done. It would appear however that few want to take the risk.
Some argue that as Ireland has reserves she can afford to let the storm pass as her government can use the reserves for around the next 8 months or so. I think that this is flawed thinking because what will individual’s and companies do? What if they wish to borrow? If you consider the position of what Irish fixed-rate mortgages must be priced at or what interest-rate her companies would borrow at and hence the return which would be required if investment would be economic I hope my point becomes clear. This is exactly the sort of situation which caused the 2008 recession. She is in danger of an interest-rate driven economic shock which from her weak starting position would have 1930s type consequences.
Let me give you a concrete example of this back on the 28th of October I wrote this about some borrowing by the Bank of Ireland ( just to be clear this is a commercial bank with a confusing name not the central bank).
Another is that Bank of Ireland has issued Euro 750 millions of 2 and a half-year borrowing, on the face of it this sounds good and maybe you will find some journalists who say this. However if you stop and think that this money has been borrowed at 5.9% you then get two very worrying thoughts.
1. Exactly where is Bank of Ireland going to be able to lend this money out at a profit when interest-rates are so low? In case you are wondering its standard rate for mortgages in Ireland is 3.4%. So any new mortgage business is at a margin of -2.5%.
2. Bank of Ireland has a state-guarantee so the fact that it has had to pay 5.9% for relatively short-dated borrowing is worrying for the sovereign nation too
This troubled me at the time and if you factor in the fact that sovereign yields have shot up since then the rate now would be perhaps 2 points higher if anyone would lend at all. Those who have actually purchased this paper may well be crossing their fingers and putting it in their hold to maturity book (if there is room….) as so far it has lost 10% of its value which for such a short-dated bond in such a short space of time is quite an achievement. It will hardly encourage them to return.
A possible UK Consequence
There is an anomaly in the UK whereby Post Office Savings are actually provided by Bank of Ireland. If we put the dangers of this to one side perhaps there is some hope for better interest rates for them as for the Bank of Ireland it might be a relatively cheap way of getting some deposits.
Financial markets ebb and flow and today is likely on its own to see something of an improvement. The Euro zone politician’s are likely to try to come up with something and if you are a sophisticated investor you are likely to want to take your profits and get out of the market as this weekend carries a lot of political risk. All sorts of rumours are flying round about what is being proposed in Seoul as I type and Irish government bond yields are falling.
However in the hubbub and excitement please keep in the back of your mind that so far Euro fudge has proved to have an initially sweet taste but then sickly after-effects emerge.