The Ratings Agencies Strike Again
Yesterday the euro area debt crisis seemed to take a turn for the worse when first the ruling Spanish socialist party faced a stunning electoral defeat in municipal elections over the weekend, and then both Italy and Belgium were hit by "outlook downgrades" (from "stable" to "negative") by S&P. Belgium also faced "outlook" action from Fitch. Italy is currently rated single A+ by S&P and Belgium AA+. As regards Italy, which carries one of the heaviest government debt loads in the euro area, market perceptions have lately been on the mend. The same was true of Belgium, which seems to be quite able to carry on without a government (the increasingly obvious empirical evidence that a government is not really needed could yet give people ideas).
These more benign market perceptions were rudely interrupted yesterday - and this comes at what is evidently a somewhat less than propitious juncture, with the potential for a Greek default hanging like the sword of Damocles over the European banking system already.
Italy was – in term of perceptions – thought to be "just like Japan," in that a large proportion of its debt is held by domestic investors. This view is probably too simplistic, not least because the country sports a yawning current account deficit.
Spain – Incumbents Swept Away By Darkening Social Mood
In connection with the socialist party losing municipal elections in Spain, we would note that its opposition is no less likely to hew to a deficit cutting and austerity regime. However, this electoral defeat, and a concurrent fifth rout of the German governing coalition in local elections (which Mrs. Merkel blamed on Fukushima, of all things) are simply harbingers of the bearish social mood that has Europe in its grip these days. Incumbents always lose elections when the social mood turns negative – and it does not matter where in the political spectrum they are located. Thus in Spain, the conservatives are the winners of this phenomenon, while in Germany, the authoritarian left is the big winner, with the "Greens" making ever bigger inroads. The formerly tiny environmentalist movement is about to grow into Germany's most formidable political force. Even though Karl Marx is probably in Hell and doesn't have much to laugh about, we suppose he's in a slightly better mood nowadays.
As Bloomberg reports regarding the election in Spain:
Spain's Socialists suffered their worst electoral defeat in more than 30 years as voters punished Prime Minister Jose Luis Rodriguez Zapatero's party for soaring unemployment and spending cuts that aimed to shield the country from Europe's debt crisis.
With 91 percent of votes counted, the opposition People's Party won 38 percent of the vote in municipal elections, compared with 28 percent for the ruling Socialists, the Interior Ministry said. The Socialists lost control of Barcelona, the country's second-biggest city, for the first time since 1979. Regional election results weren't yet available.
"Tonight will not be a good night for the Socialist party," Elena Valenciano, the spokeswoman of the party's electoral board told reporters in televised comments after polls closed at 8 p.m. in Madrid.
The transfer of power in the regions threatens to revive concerns over Spain's budget deficit as newly elected officials may reveal weaker finances than their predecessors reported. The defeat, capping a week of street protests, may further weaken Zapatero as he seeks to convince investors he can tame the euro- region's third-largest budget shortfall and avoid following Greece, Portugal and Ireland in accepting a bailout.
This is too funny. Now worries about Spain's finances are back on the table again, because it is suspected that someone might actually begin telling the truth! You couldn't make this up. Anyway, it highlights the fact that people's heads have been firmly planted in the sand with regards to Spain. As we have previously pointed out (scroll down to "Crisis Fatigue In Spain"), the numbers we have been fed are just not credible. One of the biggest real estate bubbles of all time has burst in Spain and it seems highly likely that a lot has been swept under the rug to "maintain confidence."
Italy – The Elephant In The Room
Business Insider yesterday posted a "chart of the day" which we reproduce below. What is quite clear from this is that any big market wobbles in Italy's debt would be rather detrimental to the euro project. It is already widely known that a Greek default, by dint of putting further pressure on Portuguese and Irish debt, could potentially bring many euro area banks to their knees. Alas, the bond markets of these countries are small enough to at least make it not completely unimaginable that the problem could be handled, not least because the ECB has bought up a large chunk of their bonds in the meantime. If there's a problem with Italy, the euro area banking system will face an unmanageable situation. This one is both too big to fail and too big too bail.
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Exposure of various euro area banks to PIIGS debt in graphical form, via Business Insider. The Italian banks themselves are of course the most exposed to Italian government debt. The total amounts involved are staggering.
We have written about Italy about a year ago (scroll down to "Italy is quietly lying in wait") – at a time when it was still widely believed that nothing untoward was likely to happen. We presented a rather worrisome analysis by Roger Bootle of Capital Economics on that occasion, from which it is worth quoting a passage again:
Since the 1970s, the Government has consistently lived beyond its means and public debt has risen to around 115 percent of GDP – broadly in line with the Greek ratio. And since joining the euro, Italy has steadily lost competitiveness," Bootle wrote. "We think that it might take a decade or more of stagnant or falling wages to restore full competitiveness." The only chance of Italy getting its debt-to-GDP ratio below 100 percent would be for it to run a budget surplus of 5 percent over 15 years. "If doubts grow over whether the Government is willing or able to do this, Italy could fall into a so-called "debt trap." Under this scenario, rising borrowing costs lead the debt-to-GDP ratio to increase at an accelerating rate, leaving the Government with no choice but to default.”
"If the Government were to default on its debts and investors were forced to take a large haircut of say 50 percent, this would wipe out around 80 percent of Italian banks' tier one capital at a stroke, causing domestic financial market meltdown," he said. Bootle said foreign investors would face losses of around €400 billion. "Uncertainty about exactly which banks were worst affected would almost certainly lead to the seizing up of interbank lending markets and could prompt another deep global recession," he said.
As we have noted several times already, while Spain is the lynchpin, Italy could become the coup de grace for the euro area.
At present, no-one seems especially worried yet though. As reported by RTT News in connection with Italy's credit outlook downgrade:
Rating agency Standard & Poor's downgrade of Italy's rating outlook must be treated as a wake-up call to the government and a downgrade is unlikely in the near term, UniCredit Research said Monday.
On Friday, S&P cut the Eurozone country's rating outlook to negative from stable. The agency said the move reflects its concerns over the heightened downside risks in the government's debt reduction plan.
Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering, and potential political gridlock could contribute to fiscal slippage, the rating agency said.
's&P's move should be read mostly as a wake-up call to the government, whose effort in terms of growth-enhancing measures has clearly weakened in recent months," UniCredit's Milan-based Fixed Income Strategist Luca Cazzulani and Economist Chiara Corsa said.
"A rating downgrade is not our central scenario."
"The recently published National Program of Reforms provides only a preliminary framework for the government's agenda on growth-boosting measures, and S&P would have probably preferred more concrete measures, including a stronger focus on liberalizations."
Given UniCredit's exposure to Italian government debt, it better hope a downgrade does not become the "central scenario." In other words, whatever the bank says must be discounted by the fact that it is its book that is talking as well. As of today Italy's 10 year yield clocks in at 4.80% – we would suggest a break of the recent high at the 5% level would be cause for grave concern.
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The yield on Italy's 10 year government bond – currently at 4.8%, which is still inside the elevated trading range it has inhabited year-to-date. A break above the 5% should be regarded as a "red alert."
The problem S&P has highlighted is a serious one. Similar to the other members of the PIIGS stable, Italy has lost its competitiveness. The country was a serial currency devaluation perp before it joined the euro. Now it can no longer do that and its "growth" prospects have diminished commensurately. We are putting the term "growth" in quote marks for a good reason – the economic growth that is recorded as a result of devaluation and inflation is entirely illusory. The root of the problem is certainly not that Italy and the remaining PIIGS now share a single currency with the likes of Germany. It is the conceit that the monetary policy of all these countries can be centrally planned and managed by a single bureaucratic entity is now finally blowing up into everybody's face.
It is not possible to implement a "one size fits all" monetary policy without creating dangerous asynchronous boom-bust cycles in the nations concerned. In fact, even if the economies of the euro area were not as disparate as they are, the attempt to centrally plan interest rates and the money supply would still be doomed to failure. The fact that these economies are so disparate only creates an additional, impossible to overcome difficulty.
We would submit that it is simply not possible to avert a major crisis – the only question is when it will happen and what its shape will be.
In this context, the Telegraph has yesterday posted a possible scenario describing what could happen if Greece were to default and concurrently re-adopt the drachma. While it does not have to happen in this manner, the scenario is certainly not completely unrealistic either (note that the paper is no longer talking about "what if" Greece defaults, it is saying "this is likely to happen when Greece defaults"). Here is the list of likely events as per the Telegraph article:
- Every bank in Greece will instantly go insolvent.
- The Greek government will nationalise every bank in Greece.
- The Greek government will forbid withdrawals from Greek banks.
- To prevent Greek depositors from rioting on the streets, Argentina-2002-style (when the Argentinian president had to flee by helicopter from the roof of the presidential palace to evade a mob of such depositors), the Greek government will declare a curfew, perhaps even general martial law.
- Greece will redenominate all its debts into "New Drachmas" or whatever it calls the new currency (this is a classic ploy of countries defaulting).
- The New Drachma will devalue by some 30-70 per cent (probably around 50 per cent, though perhaps more), effectively defaulting 0n 50 per cent or more of all Greek euro-denominated debts.
- The Irish will, within a few days, walk away from the debts of its banking system.
- The Portuguese government will wait to see whether there is chaos in Greece before deciding whether to default in turn.
- A number of French and German banks will make sufficient losses that they no longer meet regulatory capital adequacy requirements.
- The European Central Bank will become insolvent, given its very high exposure to Greek government debt, and to Greek banking sector and Irish banking sector debt.
- The French and German governments will meet to decide whether (a) to recapitalise the ECB, or (b) to allow the ECB to print money to restore its solvency. (Because the ECB has relatively little foreign currency-denominated exposure, it could in principle print its way out, but this is forbidden by its founding charter. On the other hand, the EU Treaty explicitly, and in terms, forbids the form of bailouts used for Greece, Portugal and Ireland, but a little thing like their being blatantly illegal hasn't prevented that from happening, so it's not intrinsically obvious that its being illegal for the ECB to print its way out will prove much of a hurdle.)
- They will recapitalise, and recapitalise their own banks, but declare an end to all bailouts.
- There will be carnage in the market for Spanish banking sector bonds, as bondholders anticipate imposed debt-equity swaps.
- This assumption will prove justified, as the Spaniards choose to over-ride the structure of current bond contracts in the Spanish banking sector, recapitalising a number of banks via debt-equity swaps.
- Bondholders will take the Spanish Banking Sector to the European Court of Human Rights (and probably other courts, also), claiming violations of property rights. These cases won't be heard for years. By the time they are finally heard, no-one will care.
- Attention will turn to the British banks.
Perhaps this is a tad too apocalyptic, but then again, the fact that the fate of the rickety euro area banking system is deeply intertwined with that of its sovereign debtors can certainly not be wished away.
Belgium Needs A Government? Really?
According to reports by Reuters and others, the ratings agencies are worried about the continued absence of a government in Belgium. It appears to have escaped their notice that no-one else is really missing the government. Things are pretty much continuing as before, with continuity assured by the well-entrenched bureaucracy.
If the country's inability to form a government threatened deficit- and debt-reduction goals, S&P said Belgium's AA+ rating could be downgraded within six months.
The strong warning places Belgium, which has a debt-to-GDP level of almost 100 percent, among the riskier states in a region being pummeled by a debt crisis that has led to bailouts for Greece and Ireland amid concerns Portugal and Spain might need rescuing too.
In the latest in a series of negative rating moves on euro zone states by the three main agencies, S&P said it was lowering the outlook from stable to negative largely because of Belgium's failure to form a new government since elections in June.
Analysts said they were not surprised by S&P's decision, which was a clear sign the country needed to come up with a comprehensive deficit-reduction plan soon.
"The key issue when it comes to Belgium, in contrast to most other euro zone countries, is they don't really have a serious fiscal consolidation package in place and obviously there's the political uncertainty," said Nick Kounis at ABN Amro.
"The deficit doesn't look that bad, but of course the government debt levels are high … There is the contagion risk in what is still quite a vulnerable environment."
The yield on Belgium 10-year government bonds rose, with the spread over benchmark German Bunds — a key indicator of investment risk – widening by 10 basis points to 110 bps.
One great advantage of having no government is that there is nobody in charge who could make stupid mistakes. As soon as a new government is formed this will no longer be the case. In fact, we think the man from ABN Amro has it exactly the wrong way around. Having no government produces political certainty, while having one is liable to produce political uncertainty. A comprehensive debt reduction plan could conceivable be worked out by the "caretaker" government as well. Simply cut spending – how difficult can it be?
Fitch became the second ratings agency to threaten Belgium with a credit downgrade on Monday, saying a lack of government undermined budget efforts in one of the euro zone's most indebted states.
Fitch affirmed its AA+ rating for Belgian government debt, but said its outlook was now negative rather than stable, mirroring Standard & Poor's warning from last December.
"The negative outlook reflects Fitch's concerns over the pace of structural reform in the coming years and the ability to accelerate fiscal consolidation without a resolution to the constitutional crisis," Douglas Renwick, a director in Fitch's sovereign group said in a statement.
Evidently, 11 months without government have not really made the situation any worse. So why this sudden worry about whether Belgium does or doesn't have one? Who cares?
Bank Of England – More Excuses
Last week the latest twist of the "stagflation in the UK" saga made its appearance, as CPI "price" inflation stormed to new high ground. As the FT's Alphaville blog noted, BoE chairman Mervyn King is "crucified again."
King had to write his umpteenth letter to the chancellor to explain away the fact that U.K. CPI keeps hitting fresh highs and assuring the head of HM's treasury that this has absolutely nothing to do with the BoE's money printing efforts and holding its benchmark interest rate at about one tenth of the level of the official "inflation" rate. The entire "Dear Chancellor" missive can be found here (pdf). Below is an excerpt:
As set out in my previous letter, the current high level of inflation reflects three main influences: the increase in the standard rate of VAT in January to 20%, higher energy prices and increases in import prices. Although the impact on inflation of these factors is difficult to quantify with precision, it is likely that had they not occurred, inflation would have been substantially lower and probably below the target [...]
As explained above, inflation is high at present because it is being pushed up by the rise in the standard rate of VAT, higher energy prices and import prices. But unless continually repeated, the impetus from these factors should gradually diminish and, as it does, inflation is likely to moderate. The extent and timing of that decline are, however, uncertain. Over the past two weeks alone we have seen how quickly commodity prices can change. And there are both upside and downside risks to the inflation outlook [...]
See? The BoE's money printing has nothing whatsoever to do with it. And neither has the money printing occurring elsewhere, as Helicopter Ben (a.k.a. "The Bernank") also keeps assuring us that all these pesky rising prices are merely "transitory" phenomena that are not at all connected to the vast increase of the money supply. The fact that broad "Austrian" U.S. money supply TMS-2 is up by 42% since 2007 has no influence on prices in the U.S. Rising prices – except rising stock prices of course – are all the fault of the tooth fairy and her cadre of financial terrorists inhabiting the crude oil and other commodity pits in Chicago. How did former treasury secretary O"Neill once put it? "Money can be more lethal than a bullet."
U.K. CPI, year-on-year rate of change. It's everybody's fault, just not the central bank's. Keeping its interest rate at 0.5% and continuing with "QE" is the only appropriate response. And here we thought that central bank rate decisions depended on the "incoming data?"