July 25, 2012
Where has all the optimism gone? A few weeks ago, the EU seemed to be back in the driving seat. The Council, driven by Italy and Spain, had extracted a major concession out of Germany and there was a sense that the interest of the European Union as a whole had been put for once to the fore.
Now this all looks like old history. Spain, the country with the worst unemployment — apart from Greece — looks to be shut out of the bond markets completely in the days or weeks ahead. This means another massive injection of troika funds, but more worryingly will also put Italy under the spotlight again, and so we will be back to square one.
Recent data indicated that Europe is heading into recession, quickly. For example, yesterday’s survey data on France showed that manufacturing was at its weakest since 2009. As the economies of Europe contract, something odd is happening. Despite all the deficit-tightening going on around the eurozone which is aimed at bringing down the overall debt levels of the member countries, the actual debt/GDP ratios are going the opposite way. Latest numbers show that the actual debt-to-GDP ratio in the EU went up this year to 88pc from 86pc a year earlier. The economies are slowing quicker than governments can cut back.
But while most of the commentary in Ireland today will be focused on the bond yield in Spain, the real worry for the euro is not the meltdown of the bond markets but the melt-up from the bond markets to the short-term interest rates. Spanish short-term interest rates are now above 6pc. This means that the financial markets expect big risk in Spain not in the next five or 10 years, but in the next five or 10 weeks.
It is clear from the movement of short-term interest rates in Germany, Austria, Netherlands and France — all of which are now in negative territory — that investors are preparing themselves for the breakup of the currency. In all the above countries, investors are now paying the governments to be able to lend to them. We are at the stage where the return of capital is the new return on capital. Getting your money back is the name of the game, not getting a return on your money.
Obviously the opposite is the case in the periphery, where short-term rates have moved out again.
The question for everyone is how long can this last. The IMF has recently published a report suggesting it is losing confidence in the eurozone experiment. In Spain the region of Valencia has said it needs financial support to pay its employees. Will it be the last? Greece is back saying it can’t keep to its targets and in Italy there are reports that Silvio Berlusconci is thinking of running again in the election to be held in six months — and just for good measure, its bond yields are over 6pc too.
There is real pressure now on Mario Draghi to introduce another round of central bank buying of government bonds via the banks. This is termed the LTRO or as others call it the largest “cash for trash” scheme in the world.
However, when you look at the lack of any permanent solution for the eurozone it does come down to what seems to be a total breakdown in trust between the creditor and debtor countries. The creditor countries around Germany don’t believe that the debtor countries will stick to their word. In addition, when they look at countries like Ireland and anticipate a wave of mortgage defaults, they must consider how it will end.
From the perspective of the peripheral countries, there is a real grievance that the creditor countries don’t appear willing to accept their responsibility for careless lending in the boom. Someone needs to knock heads together. The euro’s economic problem is recession and no growth; its financial problem is too much debt; and its political problem is that there’s no one to knock heads together.
Many people look to Angela Merkel, but those who watch her closely confirm that she is a very cautious politician and never moves far from her electoral roots. Her grassroots are telling her they’ve had enough of these bailouts. So she has a choice in the next few months of bulldozing through something that’s unpopular in Germany or doing nothing. Given that she is a politician who also faces an election next year, what do you think she will do?
This implies that the only person who can act to stabilise the situation — because believe me the euro is in serious trouble — is Mario Draghi. Spain and Italy can’t deal with these interest rates, particularly as it is the euro that is causing these countries to be penalised. If you doubt that interpretation, compare the interest rates in the UK with those in Italy and Spain. British interest rates are heading towards negative territory despite the fact that Britain is in a recession and has a debt burden comparable to Spain’s. Nobody believes it will default and hence the low interest rates.
The reason this is the case is that it has its own currency with its own central bank and the market knows that the Bank of England will and has been stepping in to buy Gilts when it has to and it will let the currency fall to whatever level is necessary. The problem with Spain and Italy in a nutshell is that they both use someone else’s currency. If you can’t print or change the value of the currency you use, then it’s not yours, period.
And because they do not use their own currency, their debts are by implication in a foreign currency. Therefore, there is always a risk of default because they can’t control the value of their debts. In Ireland, we are in the same boat, but have even higher overall debts, public and private.
Unless the ECB opens up its balance sheet and makes a commitment to buy all Italian and Spanish debt, the end of the euro is a very real prospect.