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Thursday, 4 August 2011

Europe and the Euro-zone: It seems that the shit hits the fan, where it concerns Spain and Italy.

If you follow the messages on Twitter and in the financial news sources, you are struck by an increasing sense of panic in the financial market, concerning the financial situation of Italy and Spain, which leads to enormous yields on Italian and Spanish bonds.
The Greek, Irish and even Portuguese sovereign debt crises were mostly painful, annoying and awkward, like being stung by a wasp. The equivalent for a Spanish and Italian sovereign debt crisis, however, is being hit by a jumbo jet: there are a lot of similarities between those events, but the impact of the latter is way bigger.
The national debt of Italy alone is a staggering €1.7 trn Euro and although the national debt of Spain is relatively low, it is still €886 bln. The thought that the other countries in the Euro-zone should warrant this huge amount of debt to keep the Euro alive, is already mindboggling.
But, it is exactly this thought that is turning more and more into reality, due to the continuous panic on the financial markets. Although the sovereign debt crises in Spain and Italy have a different background, there are a few highlights in both economies that might explain it (see table)

Large unemployment (> 20%)
A huge national debt (>115%)
Huge youth unemployment (>40%)
Anemic economic growth since 2000
A large budget deficit  in 2010 (>9%)
Organized crime
Anemic economic growth
A government leader that lost authority,
due to his erratic behavior
Anemic industry
A strong division and acrimony between the wealthy north  and the struggling south regions of the country
A residential real estate bubble
Widespread corruption

If you would look at the countries individually, there would be no reason for acute panic:
·    Italy has a huge debt, but the country has also a modern, vivid manufacturing and (financial) services industry and an adequate earnings capacity for the future.
·    Spain is a problem child with its unemployment, its RRE and CRE bubble, its anemic manufacturing industry and its lack of adequate earnings capacity for the near future. However, it has a national debt that is not especially high (64.5% of GDP according to the IMF).
The current reason for the panic on Spain and Italy, however, is that Europe and the Euro-zone messed up big time in dealing with the Greek, Irish and Portuguese sovereign problems. With an initial ‘extend and pretend’ strategy for Greece, Ireland and Portugal, the Euro-zone lost all authority. This was reinforced by the fact that the European leaders were openly quarreling and jawboning on about every subject, concerning the rescue of these three PIIGS-members.
The Euro-zone acted like a cowboy that was provoked into a big duel, but didn’t have enough bullets in his gun. All bullets have now been shot at Greece and now the gun is empty, while the more dangerous cowboys Spain and Italy are approaching. The financial markets sense this: hence, the panic.
To give you a smell of this panic, I collected some articles on the latest developments in the Euro-zone. Here are the pertinent snips of these articles, accompanied by my comments:
"Developments in the sovereign bond markets of Italy and Spain are a cause of deep concern. These developments are clearly unwarranted on the basis of economic and budgetary fundamentals in these two Member States and the steps that they are taking to reinforce those fundamentals. In fact, the tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis.
The systemic nature of the sovereign debt crisis was recognised by the Heads of State and Government of the euro area at their meeting of 21 July. At that meeting, a unique solution for the crisis in Greece was found involving a partnership between the official and private creditors, but it was agreed that private sector involvement would not be a standard feature of the euro area’s crisis management.
Agreement was also reached on ground-breaking measures that will reinforce the euro area’s systemic response to the crisis by enhancing the effectiveness of the European Financial Stability Facility (EFSF), by reforming euro area governance structures and by adapting our working methods to the needs of crisis management with each institution playing its part
In my opinion, it is wise that José Manuel Barroso now confirms, what everybody with a brain already knew: that there is a true and very dangerous financial crisis situation around the Euro and Euro-zone. A crisis that might lead to an implosion of the Euro-zone when not handled properly. One trader called it ‘taking the cat out of the bag’. I call it: confessing the obvious truth.
Concerning the red and bold text: The rescue plan of July 21st might have been a unique solution for the crisis in Greece, but it was recognized by the financial markets for what it was: too little too late!

Reuters issues its take on the news with the article: WRAPUP 4-EU says capacity to solve debt crisis in doubt:
The European Union acknowledged on Wednesday that investors now doubt whether the euro zone can overcome its debt crisis and Italy's Silvio Berlusconi called for more action to ward off market attacks.
European Commission President Jose Manuel Barroso said a surge in Italian and Spanish bond yields to 14-year highs was cause for deep concern although they did not reflect the true state of the third and fourth largest economies in the currency area.

"In fact, the tensions in bond markets reflect a growing concern among investors about the systemic capacity of the euro area to respond to the evolving crisis," Barroso said in a statement.
He urged member states to speed up parliamentary approval of crisis-fighting measures agreed at a July 21 summit meant to stop contagion from Greece, Ireland and Portugal, which have received EU/IMF bailouts, to larger European economies.

But neither he nor European Monetary Affairs Commissioner Olli Rehn offered any immediate steps to stem the crisis, which has flared again with full force less than two weeks after that emergency meeting.

Italy has borne the brunt of a selloff triggered by the unresolved debt crisis and fears of a global economic slowdown.

With many policymakers on holiday, there seemed little prospect of early European policy action, although euro zone governments were in telephone contact about the situation.

German Economics Minister Philipp Roesler said Italy and Spain were not even discussed at Berlin's weekly cabinet meeting which he chaired in place of Chancellor Angela Merkel, who is on vacation and did not call in.
The euro zone's rescue fund cannot use new powers granted at last month's summit to buy bonds in the secondary market or give states precautionary credit lines until they are approved by national parliaments in late September at the earliest.

Italy and Spain could offer new austerity measures to try to placate the markets, but Rome has just adopted a 48 billion euro savings package and Madrid's lame duck government has just called an early general election for Nov. 20.

Concerning the red paragraphes:
·    1. Barroso, as well as Olli Rehn didn’t do anything, because they couldn’t do anything. This proves the total inability of the current European governance model, which requires the approval of all European/ Euro-zone governments.
·    2. This is probably a blatant lie to spread a false image of self-confidence. If the situation in Spain and Italy was not discussed, the German government officials should be fired.
·    3.As stated above: the total failure of the current European governance model.
·    4. The Italian austerity measures of €48 billion are pathetic, when compared to the state debt of €1.7 trn, whether you like it or not.

The Wall Street Journal reports of an ECB Emergency meeting: ECB Meets Amid Debt Crisis


The European Central Bank's policy council meets Thursday amid some expectations that it may resume the purchase of euro-zone government bonds to prevent the debt crisis from spreading to Italy and Spain.
Many market-watchers are doubtful of a major announcement on bond purchasing, but nonetheless will be tuned in for ECB President Jean-Claude Trichet's post-meeting press conference at 1230 GMT.The ECB is widely expected to hold its key interest rate unchanged at 1.5% at the meeting, after raising rates twice since April.

It has been four months since the ECB last used its Securities Markets Program for selected bond purchases to support weaker government bond markets. But sharp declines in Italian and Spanish government bond prices, sending yields up to dangerous levels, have prompted speculation that the ECB will opt to step back in.

The ECB is the only euro-zone institution that can move quickly enough to stop the debt crisis from spreading out from earlier casualties Greece, Ireland and Portugal. ECB board member Jose Manuel Gonzalez-Paramo said last week that the ECB's bond-buying program is continuing, despite a decision by euro-zone leaders to allow the euro-zone bailout fund—the European Financial Stability Facility—to directly buy sovereign bonds in the secondary market. Nomura economists in a research note Thursday said that reactivation of the SMP was a possibility because of delays in processing the changes to the EFSF mandate.

"Amid the turmoil that is gripping the markets due to expanded EFSF implementation risks, they might just be tempted to use it as a stop-gap measure," Nomura analysts wrote. "Such a stance would be a near-term positive for Italy and Spain in particular."

The ECB only reluctantly set up the SMP program in May 2010, amidst an existential crisis for the euro as Greece was on the verge of default, because it doesn't like to indirectly provide funding to governments by buying its bonds. But the ECB would have no choice if the big economies of Italy and Spain were threatened with a fiscal meltdown.

"It is difficult to pinpoint the threshold at which the ECB would revive its SMP program, but we are convinced that the ECB will ultimately prevent any systemic event related to Spain or Italy," said Goldman Sachs economist Dirk Schumacher.

The ECB is widely expected to hold interest rates unchanged in order to await clearer signs on the economy. Mr. Trichet should offer clues on rates early in his introductory statement. If he says the monetary policy stance is "accommodative" and that the bank continues to monitor "very closely" developments related to risks of rising inflation, then another rate rise this year is likely.

Concerning the red paragraphs:
·    1. Yes, the ECB can act, where the government leaders can only talk. And yes, waiting until September seems not an option in the current crisis. But, if buying ‘junk bonds’ from the Spain and Italy is the solution that will calm down the markets is questionable. It would be like QE1 for the European Union, thus causing the inflation in the financially more stable North-Western Euro-countries to soar and the ECB would be stuck with a pile of ‘worthless’ sovereigns. And whenever was more debt, the solution for too much debt?

Cynically speaking: the best thing that could happen to Europe, was a major (financial) event in the USA, Russia, Japan or China. Only this would have the power to distract the financial markets from the smouldering forest-fire that is the Euro-zone currently

·    2. Here again, the structural weakness of the Euro-zone is disclosed: The North-Western Euro-countries could use very much higher interest rates to fight inflation. For the PIIGS, however, higher interest rates could mean the ‘death blow’.
And what all these plans don’t do, is taking away the structural imbalances between the North-Western countries in the Euro-Zone (export surpluses in combination with a capital deficit) and the PIIGS (import deficit and capital-surpluses).

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