Spain faces a simple choice between devaluation and economic depression

We open this week with the realisation that the recent lull in the crisis in the Euro is now over. Last week saw rising government bond yields in Italy and particularly Spain which has continued this morning. However let us look first at another signal which is the Euro exchange rate and whilst we will briefly note that the Euro has touched 1.30 this morning versus the US dollar this is not the one I mean. In some ways it is the exchange rate versus the UK pound sterling which is signalling something of a change as it pushes forwards to 1.2170. Yes the poor old battered pound has been making some progress after a weak period where the Euro had bullied it! Indeed it has been making something of a surge today. Yet if you look at the UK with a coalition government looking rather hapless and frankly often incompetent and a weak economy we do not see the foundations of a strong currency unless the competing alternative outlook is worse.

Actually £ has been making a recovery since the Euro crisis began as the dog days of 2007/08 and its fall to 1.05 have been replaced by rises of 7.8% in 2009,3.3% in 2010 and 4.4% in 2011. So are Florence and the Machine right to sing?

The dog days are over
The dog days are gone

We will have to see if this is a new adventure for the £ and a return to a stronger period. But we need to take care as this is a battle of lightweights and who is relatively weakest rather than a battle of heavy or even middleweights! If we look for a currency which has managed periods of persistent strength we see that the Yen has moved from 107 versus the Euro on Friday to 104.8 today.

Collateral Damage?

One of the ironies of such a situation is that neither the Bank of England nor the Bank of Japan will be particularly happy about this. The Bank of England wants to re-balance the UK economy and hopes -rather against the actual evidence- that a weaker £ would help whilst the Bank of Japan had been hoping that the recent Yen weakness after a long period of strength might carry on.

One point often ignored is that a weak Euro will help the economies of the periphery if it is sustained. Furthermore it is an example of a market mechanism acting in a self-correcting way which is rather refreshing after all the government and central bank interference of these times. Indeed it has been shown to actually work in the past as opposed to all these official interventions which once you penetrate the bombast have very weak supporting data.

You don’t get much for a trillion Euros these days

As the situation deteriorates you may be wondering about the just over a trillion Euros of three-year liquidity that the European Central Bank provided in its December and February operations. As I have explained before Italian and Spanish banks used it as a source of cheap cash (initially 1%) to invest in higher yielding bonds, and rather conveniently these happened to be their own sovereign bonds.

If we look at the Spanish government bond market we see the effect of this. Spain’s banks mostly invest around the three year region and at this point you may be thinking that the three year term of the liquidity offer was not a coincidence and you would be right! If we look at the yield on Spain’s three year bonds we saw it plummet from over 6% in late November to 2.7% at the beginning of March. This is a lot nearer to debt monetisation that the media have cottoned onto. But if we return to today’s theme we have seen rises in the yield since then to above 4% at the end of last week. And this has been reinforced by a rise of 0.22% to 4.37% this morning.

Did the money run out?

No I do not believe so. In fact if you do the calculations Spanish banks received enough funding to allow them to keep going until late summer. Actually the latest problem appears to be exactly the reverse. Investors have been spooked by how much they borrowed!

According to the Bank of Spain her banks borrowed an extra 75.2 billion Euros from the ECB in March which mostly represents take-up of its second major three-year liquidity operation. This took total borrowing by Spanish banks from the ECB to 227.6 billion Euros or 29% of the borrowing from it.

So there you have it the often contrary nature of humanity as shown by investors has played out one more time. The implicit size of the operation leads to success which leads to failure when the implicit size becomes explicit. The bit that can really mess with your mind is the fact that  fear that this was pretty much predetermined……If so why did it happen?

The elephant in the room

I often use this phrase figuratively but this time I mean it literally as an injury has revealed that the Spanish King Juan Carlos has been elephant hunting. This has two initial flaws. Evidence shows that elephants are intelligent and we should not kill intelligent animals for “fun”. Secondly a man who shot and killed his brother with a gun should be allowed nowhere near one. Indeed as his grandson recently shot himself in the foot perhaps the ban should be extended to the whole family.

The same man recently proclaimed himself as being unable to sleep due to the level of Spanish unemployment. Perhaps sleep deprivation contributed to his accident or then again perhaps not!

Symbolic events like this can have a big effect on perceived situations.

What happened to the firewall?

If we skip beyond the logical confusion of applying a computer concept onto an economic situation we see that the boasts of only a few weeks ago are fading fast. The Euro bailout mechanisms did indeed add up to 800 billion Euros if you are willing to allow double-counting but of course in a crisis counting things twice is not only unlikely to help it will probably make things worse as it becomes exposed.

Euro zone officials are currently engaged trying to cover up their hype by getting the International Monetary Fund to raise more money so that  it can help more. This immediately raises the problem of why others should fund the problems of the Euro area via the IMF when its own members are unwilling to do so.

It also raises the problem that the IMF has not completed its last funding round. Mostly this is because no-one dares to put it in front of the US Congress but plenty of other nations have not ratified it either. So we are in danger of another episode based on fantasy.

My thoughts on the fundamental problems facing the IMF can be found here.

http://www.mindfulmoney.co.uk/wp/shaun-richards/the-international-monetary-fund-has-been-perverted-by-politicians-and-should-go-back-to-its-old-role/

The Austerity Paradox

The problem here is that nearly everybody has rumbled the problem of applying austerity to a weakening economy. It is simply that you weaken the economy further which then requires more austerity as you chase your tail. Even worse the Greek experience of this shows little or no sign of any improvement.

As Spain is planning fiscal austerity equivalent to 3.2% of her economic output this year and a further 2.3% next there is a danger of a steep downwards spiral. If we look at the industrial production numbers for February we were already seeing falls meaning that output was 3% lower than a year before and only 81% of output in 2005. So she is tightening the noose on an already weak economy.

What are the choices facing Spain and the Euro?

For those who are fans of several countries having the same currency I suggested the concept of the “Three Euros” a while ago. Here Spain and some of the weaker nations could joing togther and advance with a new lower exchange rate. Over time I would expect that other countries from the middle section would want to join her. Such a move would lessen the pressure for internal devaluation which as we all now know means real wage cuts on a substantial scale and would make an improvement possible.

For those willing to advance on their own then Spain could leave the Euro and reintroduce the Peseta at a new lower exchange rate.

The other choice of a fiscal union within the Euro and the introduction of Eurobonds does not seen to have much support in the area most needed -Germany- and now would probably take too long anyway. The fall in the Euro I have described above would also need to continue.

So there is my thought for you today. The option of fiscal union and Eurobonds may well have missed its window of opportunity in time and we are left with some form of devaluation. If it is not to miss its own window of opportunity it needs to happen soon.

This entry was posted in Banks, Euro zone Crisis, General Economics, Quantitative Easing and Extraordinary Monetary Measures, Recession. Bookmark the permalink.
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  • Anonymous

    Shaun – a most interesting appraisal. May I seek your guidance on one issue…. you suggest devaluation for Spain (along with others). But surely within a currency union this is not possible. Or were you referring to an overall devaluation affecting all EZ countries? Apologies for the ignorance, but you have given much food for thought.

  • kdh

    “The option of fiscal union and Eurobonds may well have missed its window of opportunity in time and we are left with some form of devaluation. If it is not to miss its own window of opportunity it needs to happen soon.”

    Well, with their record to date, I very much doubt this will be the case.  Too many vested interests in dragging this out for as long as possible, thereby getting more tax payers money to offset the banks bad debts
     

  • JW

    Hi Shaun
    Great piece. Apologies for repeating myself but until Germany squeals that TARGET2 is too much this will continue. When it does, Euro split will happen.
    Again apologies for the source but the 2 graphs in the attached piece show the monetary effect of TARGET2 rather well.
    http://www.zerohedge.com/news/exercises-parabolic-insanity

  • Andy Zarse

    Synchronicity city or what!

    My O/H is Dutch and she was complaining this morning about the poor rate she now gets on TX-ing Euros to GBP (she’s paid in Euros). 

    Not only that she was complaining about the low USD rate she got on our recent Caribbean holiday, I reckon these Euro-types have been spoiled for currency the last few years! 

    If the EZ and US economies keep moving away from each other the only result will be a Euro massacre on the exchange markets. Forex traders will shift Euros to the stronger $ and depress the Euro which will make the Germans very cross indeed.
    The SNB floor is starting to come under attack again too. I heard that someone just got away with a 1.1960 trade on Euro/CHF and rumour has
    it the SNB had to spend a billion on Thursday to protect the Chuff. The SNB is going to have a long and expensive summer defending their silly peg…
    As you say Shaun, the lull is over and it looks like life is about to get
    interesting again. Forget the
    politics, they are a sideshow… the money is starting to talk!

  • http://masterbisnis.com/eurozone-crisis-live-spanish-pm-sticks-to-budget-plans-as-bond-yields-rise-crisis-live-euro-slides-as-spanish-bond-yields-break-through-6/ Master Eurozone crisis live: Spanish PM sticks to budget plans as bond yields rise crisis live: Euro slides as Spanish bond yields break through 6%

    [...] Economist Shaun Richards argues that the sheer amount of money pumped into Spanish debt by its banks, due to the LTRO, has rebounded: According to the Bank of Spain her banks borrowed an extra €75.2bn from the ECB in March which mostly represents take-up of its second major three-year liquidity operation. This took total borrowing by Spanish banks from the ECB to 227.6 billion Euros or 29% of the borrowing from it. [...]

  • Baboo

    Apologies for a non-economic digression but thank you so much for the intriguing detail that King Juan Carlos “accidentally” shot and killed his brother. Did you know that King Bhumibol of Thailand also did the same. I could go on about a pet conspiracy theory of mine though though I believe it is out of place here.

  • http://eulands.com/wp/eurozone-crisis-live-spanish-pm-sticks-to-budget-plans-as-bond-yields-rise-crisis-live-euro-slides-as-spanish-bond-yields-break-through-6/11956 Eurozone crisis live: Spanish PM sticks to budget plans as bond yields rise crisis live: Euro slides as Spanish bond yields break through 6% | European Lands

    [...] Economist Shaun Richards argues that the sheer amount of money pumped into Spanish debt by its banks, due to the LTRO, has rebounded: According to the Bank of Spain her banks borrowed an extra €75.2bn from the ECB in March which mostly represents take-up of its second major three-year liquidity operation. This took total borrowing by Spanish banks from the ECB to 227.6 billion Euros or 29% of the borrowing from it. [...]

  • Ian_jones

    You have to wonder how Santander managed to avoid all the trouble and then buy lots of British banks/building societies. Either she had clever people in charge or just lied about its assets and losses. I can guess which.

    As for the King of Spain, what a horrible man.

  • Drf

    “The problem here is that nearly everybody has rumbled the problem of
    applying austerity to a weakening economy. It is simply that you weaken
    the economy further which then requires more austerity as you chase your
    tail. Even worse the Greek experience of this shows little or no sign
    of any improvement.”  It seems this logic is based upon the concept that government spending contributes to the real GNP rather than being a cost centre which actually retards an economy!  Hong Kong blossomed economically when the civil servant (Sir John Cowperthwaite KBE, CMG) sent there to prosper it realised that laissez faire and low taxation was what actually stimulated an economy. He is now revered still in Hong Kong. 

  • http://meetmedaily.com/eurozone-crisis-live-spanish-pm-sticks-to-budget-plans-as-bond-yields-rise-crisis-live-euro-slides-as-spanish-bond-yields-break-through-6/ Eurozone crisis live: Spanish PM sticks to budget plans as bond yields rise crisis live: Euro slides as Spanish bond yields break through 6% | Meet Me Daily

    [...] Economist Shaun Richards argues that the sheer amount of money pumped into Spanish debt by its banks, due to the LTRO, has rebounded: According to the Bank of Spain her banks borrowed an extra €75.2bn from the ECB in March which mostly represents take-up of its second major three-year liquidity operation. This took total borrowing by Spanish banks from the ECB to 227.6 billion Euros or 29% of the borrowing from it. [...]

  • http://www.businessdivision.co.uk/eurozone-crisis-live-spanish-pm-sticks-to-budget-plans-as-bond-yields-rise-crisis-live-euro-slides-as-spanish-bond-yields-break-through-6/ Eurozone crisis live: Spanish PM sticks to budget plans as bond yields rise crisis live: Euro slides as Spanish bond yields break through 6%

    [...] Economist Shaun Richards argues that the sheer amount of money pumped into Spanish debt by its banks, due to the LTRO, has rebounded: According to the Bank of Spain her banks borrowed an extra €75.2bn from the ECB in March which mostly represents take-up of its second major three-year liquidity operation. This took total borrowing by Spanish banks from the ECB to 227.6 billion Euros or 29% of the borrowing from it. [...]

  • Anonymous

    Hi Ray

    There are two routes by which Spain could devalue. The simplest would be to return to the Peseta as its currency and we would see it immediately marked down compared to the current Euro price.

    The other would be for the Three Euros or as Claire I think put it the Good the Bad and the Ugly! Actually though the Ugly lower priced Euro would be good for Spain…So we would replace the one Euro with 3 different currency unions with Spain at the lowest end.

  • Anonymous

    Hi kdh

    Like so many possible ways out of this morass if fiscal union/Eurobonds were to be used it would have been much better to have already deployed them.

  • Anonymous

    Hi JW

    TARGET2 is one of those factors that on a scale of 0 to 1 has an acceleration of the maximum i.e 1! Like everything else the weakening of a larger country like Spain would put a lot more pressure on the TARGET2 numbers and adding in Italy would mean some steam would need releasing..

  • Anonymous

    Hi Andy, nice musical reference too! ( The Police’s last album I think…)

    Whilst the media like the occassional the Euro is collapsing headline they do not follow exchange rates over time. For the economic impact you need to follow over months and years.

    On a one day horizon markets reversed a little later in the day and the £/Euro went back to 1.21 but it remains true that it looked like it turned at the beginning of 2009 and I wonder how high it might go. On the other side of your O/H’s argument is that back in 2007 if I remember rightly I changed up my cash at 1.50 for a holiday in Rome….

    It has been my argument that promising “unlimited intervention” was unwise and has a high chance of ending up looking outright stupid.

  • Anonymous

    Hi Baboo and welcome to my blog

    Over history there have been plenty of examples of fratricide in Royal familiies and it is intriguing that Thailand as well as Spain have seen examples of it in more recent times. Not a good advert for inbreeding is it?

  • Anonymous

    Hi Ian

    I have wondered that and have written about Santander on here. As we are friendly with Spain there is no reason why we would stop them buying a UK bank but I would have restricted how many they bought. After all “too big to fail” is one of the major problems.

    I am told that Santander has thriving businesses in South America although if it is true that Argentina has nationalised the Spanish oil company subsidiary YBF that many not be looking quite so good tonight.

  • Anonymous

    Hi Drf

    There is no chance of such austerity medicine being applied in the Euro. I was referring to the Euro branded austerity which cuts minimum wages and rasies taxes but does little to shift the deadweight in the respective economies. The problem is that the most deadweight these days is at the top!

  • MickC

    Well, the shooting of royals will surely curtail the inbreeding!

    Somewhat more seriously, do you have/are you prepared to give a forecast for the likely timing of a Euro break-up? Last September, then March were favoured by some, but they came and went and the can just got kicked further.

  • Rods

    Hi Shaun,

    Another excellent blog again.

    Just been reading up on target2 

    http://www.bundesbank.de/download/presse/publikationen/20120315.target2_balances.pdf 

    I have the following questions:

    If Spain and Italy’s increased borrowing is due to capital flight. What happens when a bank’s securities to pledge run out?
    Am I correct in this scenario?

    Either the sovereign country tax payers pick up bill to stop a ‘too big to fail bank’ from going belly up or it is allowed to fail and if the securities are worth somewhat less than their face value like Spanish mortgages then the good old Eurozone taxpayer picks up the tab?

  • http://pennystockpaycheck.com/news/?p=23208 Eurozone crisis live: Spanish PM sticks to budget plans as bond yields rise crisis live: Euro slides as Spanish bond yields break through 6% | PennyStockPayCheck.com

    [...] Economist Shaun Richards argues that the sheer amount of money pumped into Spanish debt by its banks, due to the LTRO, has rebounded: According to the Bank of Spain her banks borrowed an extra €75.2bn from the ECB in March which mostly represents take-up of its second major three-year liquidity operation. This took total borrowing by Spanish banks from the ECB to 227.6 billion Euros or 29% of the borrowing from it. [...]

  • http://forexworldblog.com/eurozone-crisis-live-spanish-pm-sticks-to-budget-plans-as-bond-yields-rise-crisis-live-euro-slides-as-spanish-bond-yields-break-through-6/ Eurozone crisis live: Spanish PM sticks to budget plans as bond yields rise crisis live: Euro slides as Spanish bond yields break through 6% | ForexWorldBlog

    [...] Economist Shaun Richards argues that the sheer amount of money pumped into Spanish debt by its banks, due to the LTRO, has rebounded: According to the Bank of Spain her banks borrowed an extra €75.2bn from the ECB in March which mostly represents take-up of its second major three-year liquidity operation. This took total borrowing by Spanish banks from the ECB to 227.6 billion Euros or 29% of the borrowing from it. [...]

  • Anonymous

    Shaun, thank you; I can follow the reasoning. May I therefore assume that each “Euro” would be traded within specific bands (with each other) and similarly with external currencies (3 bands with the pound, for example?)

  • Anonymous

    Hi Mick

    I can tell you that I think that either the Euro should break up into the Three Euros or that several countries should leave. I can tell you that I think they should do it now.

    But the can-kickers seem to enjoy the game so that they will have to be forced into it and predicting exactly when that will happen is in the “expect the unexpected” zone…

  • Anonymous

    Hi Rods

    Thank you. In a nutshell the TARGET2 system depends on the Euro itself. If it survives then they can shuffle credits and debits across national borders virtually to their hearts content. In a way the UK does this with banks from differing regions.

    But we do not need a TARGET2 because we are one country with political and fiscal union and here is the rub, what happens if someone leaves and refuses to pay or cannot pay?

    They could still shuffle around and kick cans for Greece or Portugal and maybe both but not Spain or Italy.

  • Anonymous

    Hi Ray

    That is an interesting idea and may be more paletable to the Euro members than my one! The catch is that maybe it lacks flexibility. I was thinking of them being relatively free floating but your idea of going back to “the snake” has appeal.

  • http://worldbadnews.com/world-bad-news/http:/worldbadnews.com/2012/04/16/eurozone-crisis-live-euro-slides-as-spanish-bond-yields-break-through-6/news/bad-news/insurance/ipad/iphone/ Eurozone crisis live: Euro slides as Spanish bond yields break through 6% – World Bad News : World Bad News

    [...] Economist Shaun Richards argues that a perfect volume of income pumped into Spanish debt by a banks, due to a LTRO, has rebounded: According to a Bank of Spain her banks borrowed an additional €75.2bn from a ECB in Mar that mostly represents take-up of a second vital three-year liquidity operation. This took sum borrowing by Spanish banks from a ECB to 227.6 billion Euros or 29% of a borrowing from it. [...]