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.
