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Actually £ has been making a recovery since the Euro crisis began as the dog days of 2007/08 and its fall to 1.05 have been replaced by rises of 7.8% in 2009,3.3% in 2010 and 4.4% in 2011.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