After the excitement and furore of the announcement of a loan/aid package for Ireland on Sunday evening came the opportunity for the beginnings of some reflection on the subject. This involves not only Ireland but also Portugal as she looks next in line for trouble and potentially Spain as it would appear that financial markets are questioning her position with more enthusiasm. If we take the implications of Ireland’s aid/loan package I feel that there are five issues going forwards.
The Main Issues with the Irish bailout
Firstly there is the question of the interest rate being charged. I did a calculation yesterday which pointed towards 7.5% as the interest rate for funds from the EFSM/EFSF. Now one can debate the minutiae of the calculations but not the principle that the EFSM/EFSF money will be much the most expensive part. If you had any doubt on this matter the silence from the EU has been deafening! Why not simply say?
Secondly we have the issue of the aid package not displaying the necessary firepower as the external loans will only amount to 67.5 billion Euros which is neither the “shock and awe” previously proclaimed by Euro zone ministers nor enough to dispel rumours that Ireland at a future date may have to return for more money. Just to give an example of how such funds can be used up the Irish bad bank called NAMA needs some 5 billion Euros of funding at this time which does not appear to have been addressed. At current interest rates it can hardly go to financial markets!
Thirdly we have the somewhat bizarre situation of Ireland contributing to the bailout from its cash reserve and its National Pension Reserve Fund. This leaves me with the image of Ireland’s future pensioners being forced to contribute whilst her bankers in effect do not.
Fourthly we do not have a contribution from senior debt holders at Irish banks again leaving the image in our minds of bankers escaping. This is in essence the same group of bankers who mispriced these assets in the first place. It is also true that there is a myriad of similar assets on Irish bank balance sheets such as commercial paper and certificates of deposit.
Fifthly we have the role of the European Central Bank which remains unclear. If it remains with its stated policy of ending its emergency monetary measures by January 2011 then the 130 billion Euros of emergency lending to the Irish banking system of which around 90 billion Euros is estimated to be to the Irish domestic banks will have to end and be replaced, but by what?
Not Content with dealing with Ireland the Euro zone introduces the European Stability Mechanism
You might think that European leaders would be busy with helping Ireland. You might also think that after their recent misfiring effort European leaders might deal with the subject of a permanent crisis resolution mechanism with great care. After all the talk of potential restructuring and haircuts for private-sector bondholders coincided with an acceleration in the crisis for both Ireland and Portugal as private-sector bondholders exited these markets (wouldn’t you in their shoes?).
But you would be wrong because at a time when they should have concentrated on coming up with a more comprehensive and credible plan for Ireland Europe’s leaders came up with a new plan to come in around mid-2013. The idea of an European Stability Mechanism was introduced and in essence it will be based on the EFSF the so-called “shock and awe” rescue package agreed by European finance ministers in the wake of the Greek debt crisis in May, but with one major significant difference,which is that private creditors will be involved in future debt relief or restructuring. So we have something of a compromise between the German and French positions. This deal has the implication that in future one possibility which the Euro zone has always dismissed, the idea of a sovereign nation defaulting, is no longer dismissed and becomes possible ( I mean in their minds as everybody else could see the risk all along!).
So should the ESM be called into action there are two alternatives. If it helps a country deemed to be solvent, private sector creditors are merely encouraged to maintain their exposure. But if a country is deemed to be insolvent, it would need to agree a restructuring with its creditors as a way to restore its ability to fund itself in the bond markets. The ESM could then provide liquidity support.
Comment
Seeing this immediately provoked the thought in my mind that the landscape after mid-2013 suddenly looked rather different to investors in the countries in trouble. If you are a private-sector bondholder the post 2013 environment suddenly looked at lot riskier. If you want a football analogy of this European leaders had turned into Martin Skyrtel who playing for Liverpool against Tottenham on Sunday scored for Liverpool but also accidentally turned the ball into his own team’s net. Yet again Euro zone leaders demonstrated that their time span is so different from that of financial markets that it would appear that “ne’er the twain will meet” and that they may never get a grip on them. The minute financial markets saw this plan they adjusted post-2013 prices and yields and the crisis took a new turn for the worse.
Greece gets her loans extended
The Euro zone was not yet finished and also announced plans to extend the loans it has provided to Greece to 7 years and maybe 11. I do hope that those nations which borrowed the money took my advice from back in the Spring and hedged it against assets which lasted for longer than the 3 years originally planned as for some of them re-hedging now would be expensive. It was always likely that the term would lengthen and now it has. In another bizarre development the interest-rate on the loans was raised to an average of 5.8% to match those offered Ireland.
So a country which was already paying too high an interest-rate on her loans is now paying more. In return she gets some more time in a classic case of “kicking the can down the road”. After all there was no chance of her situation being anything other than insolvent at the end of the original three-year term. As ever European Union Economic and Monetary Affairs Commissioner Olli Rehn was ready to talk.
This should now kill off any remaining doubt over Greece’s ability to repay aid.
Please remember that he has so far been an anti-seer during this crisis.
Market Response
This was not what European leaders might have imagined. Let me take you back in time to May 10th and the initial impact of the “shock and awe” plan. The Greek benchmark ten-year bond rose from a previous close of 62 to close at over 86 with its yield falling from 13.17% to 8.26%. Her bond yields did not rise again until mid-June 15th when there was a downgrade from the ratings agency Moodys. If we look at equity markets on that day then I wrote “There is a Dow Jones stoxx 600 index for Europe and it rose by 7.2%.”
If we now return to yesterday then we saw heavy falls in European equity markets with the German Dax index falling by 151 points to 6697 and the UK Ftse 100 falling by 118 points to 5550. However it is in European bond markets where the real damage was done as there was no improvement at all for Ireland overall. Shorter-dated bonds ( up to mid-2013!) managed some improvement but longer dated ones fell with her overall bond index falling to 80.17 and her ten-year government bond yield rising to 9.21%. Not much sign of a rescue there. If we look to Portugal then there was no relief there either as her ten-year government bond yield rose to 7.29%. Her concerns are immediate as she has some Treasury Bills to issue tomorrow in a bad coincidence of timing.
Real Contagion fears spread to Spain and Italy
So far during the Euro crisis the main problems have been in relatively minor countries, I mean no disrespect by this just simply that it has been the smaller economies which have been hit. However there has been fear of contagion to larger and more economically significant countries and eyes have turned to Italy and particularly Spain. This recent phase of the crisis has begun to suck Spain into its vortex. During the summer Spain’s ten-year government bond yield dropped to around 4% leading its government to relax its austerity programme as it complacently crowed about its success. Unfortunately during this phase of the crisis Spain has come under pressure with her ten-year passing the 5% yield barrier, leaving the new spending plans looking ill-considered.
The botched ESM plan hit Spain hard yesterday as her ten-year government bond yield rose to 5.5% which is now double that of Germany. There is little room for crowing or complacency now and indeed such action has reduced a more important word beginning with c credibility. As to reasons behind this there are several but if we start with, her unemployment rate of around 20%, her property boom and bust, and continued concerns about her cajas or savings banks we have a list where there has been little or no improvement.
Whisper it quietly but Italian government bond yields are rising too………
Comment
It is quite plain that European leaders are still unaware of the depth of the crisis they are facing and still unaware of the inadequacy of their response. If we look at the situation as we stand then Greece, Ireland and Portugal are all insolvent at current yields with maybe a little hope for Portugal. The bailouts so far have not changed this position and the latest ESM’s initial impact seems to have accelerated the crisis, which I imagine was not its aim!
It does not matter if you call it restructuring or a haircut but in certainly the first two nations and probably Portugal as well these are necessary as part of a route forwards. The only reason I am leaving Spain off the list is that I am waiting for her banking problems to be fully recognised, so at this point I can only say that I believe that she too is currently insolvent and will also need some debt restructuring. As we stand right now Europe can bail these countries out for a period but there is no mechanism for any real improvement except hope and in my view hope will need some help.
Is there a purpose to the Office for Budget Responsibility?
Watching the announcement of some new economic forecasts from the UK OBR I had several thoughts. Firstly I was reminded of my original thought that it was theoretically awkward for a government supposedly against Quangoes to start a new one! Secondly it reminds me also that the US has the excellent Congressional Budget Office but that has not stopped its own problems! Thirdly as it in essence was announcing forecasts to replace its previous ones which were mostly wrong I wondered if there was any purpose to this at all. Indeed since June the only bit they think they have got right is the public finances and I notice they are “broadly as anticipated” so not exactly right then!
We also got a bit of unintentional comedy in the report with the forecast of public-sector job losses dues to the governments austerity programme. this has now changed from 490,000 to 330,000 in the period since June. I know that there will always be demands from the media for such numbers but feel that the OBR should take greater care in future as if growth slows or government policy changes it may have to revise the numbers higher or indeed lower and we would then be in danger of a version of the hokey-cokey. The real answer by the way is nobody actually knows.
So as we stand the OBR should be a theoretical improvement but in practice problems and issues remain.
Notayesmanseconomics's Blog 
The OBR is crazy to enter the contentious arena of public sector job losses! Nobody, as Shaun says, knows the answer and nobody know where the cuts will ultimately occur. At least in part, the decision is political and not mathematical. To re-forecast an outcome that was previously a wild guess on the basis that another set of wild guesses has just changed seems pointless to say the least and may raise expectations in the state employment sector that cannot in fact be fulfilled. At this point in the re-alignment of UK state spending, saying nothing at all seems to be the preferred option.
Before today I had heard of the EFSF and the EFSM, today I now hear of the European Stability Mechanism ESM. Now I wonder if ESM is simply a new way of referring to the EFSM or if it is in fact a new, third mechanism. If so colour me impressed that so we have seen three mechanisms created to deal with what by my count has been only two crises so far (Greece and Ireland). If it turns out that Portugal needs help next should I expect to see a new European Mechanism created to help her, or possibly even two or three new mechanisms?
Shaun forgive me for the snide remark but with respect to Mr. Rehn’s quote This should now kill off any remaining doubt over Greece’s ability to repay aid. I don’t think there ever was any doubt over Greece’s ability to repay her rescue package.
so a government body is speculating on how many redundancies the government is going to have to make. shouldn’t they know? and if the government doesn’t know how many public sector job cuts there will have to be, who does? if noone knows, then that will be a problem when they actually come to make people redundant.
Are we still doing song metaphors?
Office of Budget Responsibility:
RONAN KEATING…….
You say it best when you say nothing at all…….
Good choice in many respects. As to the European Stability Mechanism I would suggest Fantasy by Earth Wind and Fire
If we know this is a croc, and they know we know this is a croc, what do they get out of it by persisting with the illusion? At some point the Emperor is going to have to buy new clothes!
As for Quangos, we are soon to see the demise of our Regional Development Agency to be replaced with smaller and more localised Local Enterprise Partnerships. The idea been promoted now is to have another body to oversee these LEPs on a regional basis. So we are to get rid of one Quango only to see another rise like a phoenix with an extra layer of bureaucracy for good measure. I have a feeling there are some well paid members in the public sector who just don’t get the point of the exercise!
The only purpose of the OBR is to enable the Chacellor to say that his policies have been validated by “independent” rather than “treasury” figures/forecasts.
On the job losses, I remain surprised that the Government is going to spend roughly 2% more per annum up to 2015: that wage inflation is roughly 2% elsewhere – and yet they are going to be laying off 100s of thousands of people. The public sector must be a strange world where spending increases are “savage cuts” and it makes you wonder how they are doing their accounts.
Looking at the Treasury forecasts by the way, the idea that the deficit is breing paid of by 80% cuts and 20% tax increases doesn’t stack up. Spending is not being cut – and the deficit is going to be eroded (their figures not mine) by increased tax revenues. Go figure.
As for Ireland. It’s still a bit rich that, having jumped in to save the banking sector, the Government is going to the wall because they cannot default on their banks debts to other banks (who seem offended by the thought that they might pick up some of he bill). Still, what price is being offered on Sin Fein getting the balance of power in January – and does anyone know their policy on default?
I think the ECB are performing a much more importatnt role than journalists are revealing. The securities markets programme is accounted for on a ” held to maturity” basis – what exactly does this mean, Shaun?
“Held to Maturity” means that you show the original cost of the investment on your books, rather than adjusting its value from time to time to reflect the current market value.
thanks, so sovereign bonds held by banks as capital are accounted for on the same basis?
Hi Shire
An interesting quote,from where did it come? It makes me think two things. The first is sneaky and the second is in fact that in some respects it is consistent with their mantra.
My understanding would be that they account for these bonds as if they will never sell them and will hold them until they mature and are paid out. There are several flaws in this in my view. Firstly are the issuers of these bonds likely to be able to repay on the scale required? There will be differing views on this subject but I do not think many readers will be thinking there is a 100% chance of this! After all the ECB is at this time the main buyer of these instruments.. This issue comes from the EU mantra of the “shock and awe” policy of the Spring which is that Euro zone sovereign nations will never default, not the current ESM one which seems to imply they might but after 2013!
More insidiously the ECB may be able to declare a profit on these bonds. If say for example you bought Greek bonds at 8% yield and you are an organisation which can fund itself at 1% then you make 7% per year. As you are assuming there is no default risk this is a nice profit… The flaw is exactly the same as what happened to the banks in 2007/08 in that you are making profits at the expense of your balance sheet. A mark to market system would be declaring a loss on such a bond possibly a considerable one as for example the current interest rate would be more like 12%.
So whilst they are actually making losses this is likely to allow them to ignore this and in fact declare a profit if they want.
Hi Shaun
http://www.ecb.int/press/pr/wfs/2010/html/fs101130.en.html
” The holdings by the Eurosystem of securities held for monetary policy purposes (asset item 7.1) increased by EUR 1.3 billion to EUR 128.1 billion as a result of settled purchases under the Securities Markets Programme. Therefore, in the week ending 26 November 2010 the value of the accumulated purchases under the Securities Markets Programme and that of the portfolio held under the covered bond purchase programme totalled EUR 67.2 billion and EUR 60.9 billion respectively. Both portfolios are accounted for on a held-to-maturity basis.”
Hi
Ah ok. Yes how very convenient. I was going to discuss the SMP tomorrow anyway and had reminded myself about the covered bond purchases which I havent mentioned for a while because they havent changed for quite some time.
Ironically what might be regarded as an SMP strength in this regard that it has ( I suspect this as it does not say so) apparently bought much of its portfolio at the shorter-end is currently looking a problem. When they mature where will the money come from the pay the ECB on current trends?
So, let’s see if I’ve grasped the point.
These are not illiquid loans (probably untradeable and held to term) which sit on the balance sheet, but securities created to be tradeable in financial markets.
The former can rightly be valued at “held to maturity” basis, the second should be at “mark to market”. I mean, that’s why the debt was securitised, to be traded on markets, wasn’t it?
Hi Nino
You pose an interesting question for me. This goes as follows, because of the way so many instruments have been misrepresented and distorted should we allow anything to be traded on a “held to maturity” basis? My choice would be for as few instruments as possible to be valued this way..
With that caveat yes the discussion was around perfectly tradeable securities. Although there are problems here. For “marked to market” will have prices influenced by the European Central Banks buying as if it had not bought then presumably prices would be lower. Otherwise it is wasting its time!
These are not easy distinctions and it is not always as clear cut as you might think as for example how do you deal with a tradeable security when you have funded the deal and locked in a profit? So care is needed.
What’s the end game here? Euro break up or exit of peripherals don’t seem at all likely. I suggest either the panic fizzles out over the weeks ahead, assisted by continued (sterilised) ECB purchases of PIIGS bonds, or if the crisis escalates and things are brought to a head, with the ECB getting political go-ahead for undertaking unsterilised purchases, i,e the Euro’s very own QE programme. Think what that’ll do for Asia’s inflation (and eventually ours).
I’m not sure that even see the OBR as a theoretical improvement.