The reasons behind the Moodys downgrade of Spain and the implications for Portugal and Italy too

Today sees the second day of the Bank of England Monetary Policy Committee meeting and we will be told the results of their deliberations at mid-day. There is a consensus that the result will be no change in either interest-rates or the amount of Quantitative Easing and an example of this is the poll conducted by Bloomberg where 61 out of 61 economists suggested that policy will be unchanged.This gives me two thoughts. The first is that being a member of a “consensus” has been a risky place to be in the credit crunch era. The second is that as I wrote on Tuesday the 8th of March there is a “wild card” possibility of a rise today. So just to be clear I think that out of the 61 a few should have voted for a rise to represent the probability of it fairly.

My own view remains unchanged that our interest-rates are much too low and should have been raised some time ago. I started arguing on here for a rise in UK interest-rates ( because I was concerned about our inflation prospects back in November 2009) and wanted them raised to 1.5% then and would have raised them to 2% more recently. I wish to be clear that this is for a multitude of reasons which I have put on here several times ( I have a section on UK inflation prospects) and that even so policy will be expansionary something that often gets forgotten in the debate.My policy would be merely less expansionary than we have now rather than contractionary but in my view would help to put the UK economy in a better balanced position and to face the many risks going forwards. I gave some examples of the reasons why I believe in this policy on the 10th of February. I could put it another way, does anybody actually believe that the current policy of inflation denial is going well?

More Problems in the Euro zone

Portugal

Yesterday Portugal issued the bond which matures in September 2013 although as I pointed out their website did say 2012 in its update! However the price it had to pay was not good. The Portuguese auction saw the government pay 6 % for a 2 and a half-year bond which compares with 4.1 % in September. When you look at the interest-rate paid it is not even particularly good news that Portugal was able to issue the full one billion Euros of debt that was planned.

The reason for this is that if we look at what Portugal’s government has recently been claiming is that she pays an average interest-rate of 3.5% on her national debt which is according to them below the Euro zone average of 3.6%. This sounds impressive but misses out an important detail which is the marginal cost of debt which tells us what the prospects are for new issuance of debt. If Portugal could still issue at 3.5% she would not have a problem but as this bond issue has highlighted she cannot and remember she has had a lot of support from the European Central Bank (which is now estimated to own more than 20% of Portugal’s national debt) which means that even these inflated yield levels are lower than what they would otherwise be. Also the ECB has in effect created a false market in Portugal’s debt market which is exactly the reverse of one of the prime roles of a central bank as they are supposed to regulate and end false markets and not create them!

I have a theme that one of the ways of measuring a government bond market is to look at some of the shorter dated debt and compare it with the official interest-rate. As the official interest-rate of the ECB is 1% then paying 6% for a 30 month bond looks very unhealthy indeed to my mind. Furthermore Portugal has an expected government deficit of 20 billion Euros in 2011 and has a bond of 4.5 billion Euros expiring in April and one for 5 billion Euros expiring in June. So she cannot avoid having to issue new paper and whilst she has issued some already this year more and more of it is short-term bills and it is not long before they themselves will need refinancing. Issuing bills at a time like this is an attempt to “kick the can down the road” but in addition to the obvious problems of such a policy the can is not kicked very far. It will not be long before the Portuguese government has to revise the average interest-rate on its national debt upwards.

I do not intend just to point out the failings of current policy I have emailed my suggestions for what I feel would be a better policy to the Portuguese Minister of Finance.

Usually an inconvenient truth as described above is responded to with hyperbole and frankly rubbish by Euro zone officials but Portugal’s Secretary of State said this yesterday according to the Financial Times.

(The cost of borrowing is)  not sustainable over the longer term

Spain

Regular readers will be aware that I have written about the problems in Spain’s economy for some time and I have questioned the official view that everything is under control. To break things down Spain had a housing boom and now has a housing bust which has a lot of implications for her banking sector and in particular for her savings banks which are called cajas which have many similarities to UK building societies. The cajas are in a much weaker position than her listed banks and the official policy of merging the weakest with stronger ones had to my mind two major flaws. Firstly the stronger ones must be made weaker by the exchange. Secondly any such merger muddies the figures for a while and makes it hard to tell what is actually happening. Those of a more cynical nature will wonder if the second is the real reason!Furthemore Sapnish banking regulation has allowed even the listed banks to create special purpose vehicles and offer reduced interest-rates to those in trouble but many of these measures have a two-year lifespan which is now up or about to be up…

Moody’s downgrades both Spain and her bad-bank FROB ( Fondo de Reestructuracion Ordenada Bancaria )

Moody’s Investors Service has today downgraded Spain’s government bond ratings by one notch to Aa2 from Aa1. The outlook on the Aa2 ratings is negative

Okay Why?

 (1) Moody’s expectation that the eventual cost of bank restructuring will exceed the government’s current assumptions, leading to a further increase in the public debt ratio.

(2) Moody’s continued concerns over the ability of the Spanish government to achieve the required sustainable and structural improvement in general government finances, given the limits of central government control over the regional governments’ finances as well as the background of only moderate economic growth in the short to medium term.

There is also a side-effect downgrade for Spain’s bad-bank.

Moody’s has today also downgraded the rating of Spain’s Fondo de Reestructuracion Ordenada Bancaria (FROB) to Aa2 from Aa1 with a negative outlook as the FROB’s debt is fully and unconditionally guaranteed by the government of Spain.

Comment

I had been surprised recently when so many media commentators had taken the argument of the Spanish government that the cajas could be recapitalised cheaply in such a hook line and sinker fashion. Let me explain my thoughts. the problems of the cajas I have highlighted above and I agree with Moodys that refinancing and recapitalising them will be more expensive than Spain’s government forecasts. Let us hope that we will not be going down the same path as Ireland’s troubled banks who kept coming up with worse and worse figures which means in plain language that they were a toxic  combination of incompetence and willingness to misrepresent the true position.

Moving onto the Spanish government it has a record throughout the crisis of always doing the minimum possible apart from hyperbole where the Finance Minister Elena Salgado has usually done the maximum possible! But whilst its position and authority has weakened even in Spain there is a deeper problem. It only represents about 25% of Spain’s public expenditure with the rest mostly spent by the 17 regional governments. Of these very few publish accounts at all leading to concerns about overspending. As an aside this is rumoured to be one of the reasons why the main Spanish football clubs are able to finance some of the best players in the world as they appear to be subsidised by local and regional government. Sorry if that subject is still too painful for Arsenal fans as this fact probably makes it worse… So there is no real effective control mechanism over public expenditure in Spain and a shortage of public accountability in many areas. I think we already suspect what that is likely to mean.

Another factor gets forgotten because it feels like it has become a constant but we should not forget Spain’s unemployment rate which is officially recorded at 20%. I am afraid that private-sector reports challenge these figures and report an even higher number. So there is upwards pressure on the fiscal deficit from these numbers via higher social security spending and lower tax revenue.

Linking Portugal and Spain

The two stories above do have a link as God or nature got there first and put them on the same Iberian peninsula. As they trade substantially with each other one of the fears of the Euro zone crisis is that they drag each other down. With Spanish ten-year government bond yields now at 5.5% there are challenges for her in issuing new debt now as it is getting more and more expensive.

Earlier this week I was looking at some numbers which compared ten-year bond yields with a year ago. Spain’s had risen by 1.61% whilst the UK’s had fallen by 0.31% or put another way it would have been normal back then for Spanish government bond yields to be below those of the UK….

Just to be clear I have many criticisms of the ratings agencies as they are one of the areas most ripe for reform and maybe even closure but the detail of their reports is often helpful in analysing a situation. It is a shameful situation that one of the causes of the credit crunch has emerged with if anything a stronger position.

Italy

Whisper it quietly but Italy is getting more and more sucked into this business. Her ten-year government bond yield is right on the 5% threshold. Now there is the normal significance of getting what is called a new “handle” in the change from 4 to 5 should it be sustained but added to it is the fact that if it is sustained its behaviour will start to look like…..I will let you guess!

To put the significance of this the current “rescue” mechanisms have struggled with Portugal,Ireland and Greece and they would get a severe dose of indigestion from Spain but Italy would be far too much for them as they stand. As Euro zone politicians have responded very slowly during this crisis the European Central Bank must be both scratching its head and burning the midnight oil right now.

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16 thoughts on “The reasons behind the Moodys downgrade of Spain and the implications for Portugal and Italy too

  1. You have mentioned this poll before. What question does the Bloomberg poll ask? It would be more interesting but less useful to ask what the mpc should do.

    If you had to choose one option then surely you would have tog go for unchanged rate, though other outcomes could happen.

    However suppose all 61 asked thought it 80% likely to stay the same then individually they would have to say they thought the rate will stay the same. Thus we do not get a 20 80 split of the 61 views though this would represent the ‘average’ guess.

  2. It’s me, mcgrath the 24 carat economic klutz. What puzzles me about government bond issues is when one makes a microeconomist household type assessment you’d simply not take on more debt. Is this not what the rating agents are telling recalcitrant politicians? So why don’t they rein in spending? Is it really that they don’t want to be unpopular so much that they’d take a chance with the country they are responsible for?

    • Just look at the UK for an answer about reining in spending and taking on debt. There is simply no recognition by most of the country that we are in a fiscal mess. Look at the Barnsley by-election last week. Look at the daily headlines about massive cuts (which are no more than a slowdown of the increasing expenditure). Look at the row about university fees/public sector pensions. What is the latest poltical measure to be taken in Scotland to deal with the deficit? Cancelling all remaining prescription charges.
      I have no faith left in the resolve of politicians to deal with this, as those who do are simply booted out of office. The bond market is then blamed for forcing the issue.

      • “In the bond market we trust”

        Sadly, this country (like other countries) has a plethora of self-interest groups each clamouring to protect their own positions.

        A simple read of the comments section of finance-related articles on the BBC, Guardian and Telegraph sites is enough to frighten anyone, such is the ignorance (or at least avoidance of facts) often displayed, and the entrenched, partisan views expressed.

        The basic facts re the (un)sustainability of the budget deficit, and the financial (un)sustainability of various entitlements and benefits (state pensions, public sector pensions, etc) are fairly straightforward, and would be appreciated by the vast majority, if (1) they were explained in simple terms devoid of jargon, and (2) if these explanations weren’t then obfuscated by the various self-interest groups, deploying the age-old methods of spreading Fear, Uncertainty and Doubt.

        In the UK, we’re quite fortunate to have a Government which has at least begun to address the structural defict, albeit with baby-steps, as you indicate. That these modest steps in financial restraint have evoked the opposition they have says something about the extent of the financial fantasy that much of the nation has been living in, one where basic financial reality seems to have no place.

        We can only hope that the coalition is able to hold together for a parliament, so that the deficit reduction programme is seen through at least until 2015. If not, then although the electorate may be unwilling to impose fiscal discipline upon itself, then you can be sure the bond and currency markets won’t flinch in the same way, and discipline will ultimately be enforced.

        Perhaps as people see the deteriorating fates of other deficit nations who drag their fiscal heels, they may better accept the reality of the UK’s problems, and more readily accept the measures required. But the self-interest groups are loud and strong, so I wouldn’t hold my breath…

      • Well summarised, Trevor Rothermere, cleverly without any evident partisan bias, but subtlety implying that it is partisan bias or ideology as well as financial terrorism at the base of these problems.

  3. Hi Fletch
    I agree completely and meant to make that point outright rather than kind of implying it. So apologies for not making it clearer that it would be much more helpful if the poll was conducted along the lines you suggest…..

  4. Great blog as usual, Shaun. Just looking at a couple of points, I just do not see how tears can be avoided. Do German taxpayers really know that 20% of Portuguese debt is owned by the ECB? How on earth is Portugal going to raise 9.5 billion Euroes over the next two months?

    • Hi Jiminy
      Thanks for the compliment. To answer the question I think they are becoming more aware. I will be posing some questions to the ECB about their annual accounts and will report on here about how it replies…..

  5. hello shaun

    yet again the headline rate of inflation does not make the BoE raise interest rates

    I guess they never will – the rate is there to keep the Banks from going bust – the asset inflation/ deflation worries are all about the housing market . if that market goes west ( as it surley will ) then the banks will need another bailout.

    many many excuses will be told about why the interest rate has to stay low, one day I hope the media will see why

    in the mean time where do savers put their money?

    the shares bubble ? the Gold bubble ?

    they are bubbles!!

    maybe oil – I heard a rumour the other day that the KSA cannot/will not pump more oil to cover the Lybian loss.
    too little oil ( or expensive oil ) means another resssion surely

    Forbin

  6. I know this is a little of today’s topic, but did any one hear that a couple of US states have started to pass laws that allow them to issue gold or silver coins (the Constitution doesn’t allow them to print money). Anyway, here’s the article:
    http://dailyreckoning.com/gold-the-states-and-federal-monetary-policy/
    and another funny (in completely the wrong way) article that describes how profligate some States are:
    http://dailyreckoning.com/the-second-runner-up-in-this-years-financial-darwin-awards/

    Robert

    • Hi Robert
      I was told about this earlier this week and in the circumstances it gave me a wry smile. From the US Mint website.

      “The United States Mint today announced that it is requesting public comment from all interested persons on factors to be considered in conducting research for alternative metallic coinage materials for the production of all circulating coins.”

      They are travelling in the opposite direction as “alternative” looks like it is code for cheaper to me…….

      • LOL. 5 cent nickels are worth about 7.5 cents for their metal melt value at the moment. I guess, if there’s inflation looming, they’ll need to do something to stop the people melting down all the coinage and selling it. 🙂

      • Well Alex Eames, what exactly do you mean by “…if there’s inflation looming…”? Surely inflation is already clearly evident as a marked trend, and already it is clear that it is escalating? Therefore since nothing is being done to take corrective action against it the trend line can only get worse?

      • Yes of course Drf. It was a serious understatement. 😉

        Of course the price of nickel could tank, but I doubt it could tank fast enough to keep up with Ben’s “printing press.”

  7. “Whisper it quietly but Italy is getting more and more sucked into this business.”

    Yes, I think Italy is the Big One – there is no way Germany will agree to bail out Italy (I doubt they could even afford to). At what point do you think Italy will snap? I came up with a ball-park figure of 6% on their 10 year debt based on the sizeable amount they already have. I’d put the odds of a break-up much higher than the 2% that one British commentator came up with.

    • Hi Graeme
      According to the Bank of Italy the national debt to GDP ratio was approximately 119% at the end of 2010. Not a bad year in international terms as it was 116% at the end of 2009 (however I will start to look at Italy more closely and do some more analysis on this…..). If we take this then should tonight and last nights yield levels start to be repeated allong her maturity spectrum then just below 5% would be enough….

      There are signs of shorter-dated yields rising but they are not at such levels yet….

      If you do the maths then to stabilise her public debt at a constant yield of 5% means just under 6% of Italian economic output needs to be spent on debt repayments……

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