Late on Friday evening we saw the continuation of a theme which is becoming more and more familiar. This involves Euro zone government bond markets improving with prices rising and yields falling. Examples of this on Friday, involved the Italian ten-year bond yield dropping below 6% and the Spanish equivalent dropping below 5%. However this is then followed by a ratings agency downgrading the credit rating of some Euro zone nations. Previously it has been American agencies who have played this “game” but this week it was the (mostly) French owned Fitch which took centre stage by downgrading 5 countries.
Fitch on Spain and Italy
a re-assessment by Fitch of the potential financing and monetary shocks that members of the eurozone face in light of the increasing divergence in economic, monetary and credit conditions and prospects across the region, which is also a factor in the downgrades of some other eurozone sovereign governments.
- Spain’s significant fiscal slippage in 2011 and deterioration in the macroeconomic outlook with adverse implications for the medium-term outlook for public finances.
To which it added this
The new government has also announced it will require the Spanish banks to increase their provisions by EUR50bn (EUR35bn net of tax)……………the Spanish banking sector as a whole will likely need more capital support from the state
Fitch has the same first reason here i.e a general Euro zone deterioration and then a second one which is somewhat self-fulfilling.
a permanent upward shift in Italy’s relative cost of fiscal funding and consequently an increase in the interest rate growth differential with adverse implications for long-run public debt dynamics
So there you have it Italy is in trouble because it is in trouble! This is confusing what is mostly a symptom with a cause to my mind. And of course as noted above, if high bond yields were the problem they were showing signs of improving. It would be much better I think if Fitch had made more of a case for a cause for example.
Italy’s high public debt and low potential growth rate have rendered it especially vulnerable
And that this is an issue going forwards.
the greater reliance on raising revenues (which account for around two-thirds of the planned deficit-reduction) implies that the tax burden and public spending will remain high by international standards
Added to this is the genuine doubts that Italy can carry out these reforms. For example will her unelected technocratic government be able to stay the course should the going get tough?
New data this morning has confirmed the problems ahead for both Italy and Spain. Starting with Spain we have seen her economic growth rate be confirmed at -0.3% for the last quarter of 2011 and if we look back to her recent history we see that it was Q2 of 2008 where growth was zero and that she is looking in overall terms at a four to five-year slow down. Italian business confidence has dipped to a reading of 92.1 which is the worst for two years.
Greece and her debt haircut or private-sector involvement talks
These have taken on the job of being the most like the boy who cried wolf they can be as promised deadline after promised deadline comes and goes with only a new set of promises to replace them. The latest promise expired last night.
However even if the current deal comes to fruition there is a fundamental problem which is that its impact on Greece’s national debt is too small to be of significant influence. In something which is both an irony and an example of a complete lack of long-term planning this is partly caused by the holdings of the European Central Bank which holds approximately 45 billion Euros of Greek government bonds. In addition to this you need to refinance the Greek banks who have large holdings or they would collapse and lending from the International Monetary Fund is always given on the basis that it is “senior” i.e no haircuts for it. This is before we get to the impact on Greek pension funds.
More and more talk has centred on the possibility of the European Central Bank taking a haircut on its holdings too. The ECB’s reponse remains along the lines of Dawn Penn’s ditty.
Oh perhaps we should say nein,nein,nein! But it looks as though pressure is building on this front and may be gaining some traction. The standard of official thought being what it is some ideas are at best half-baked as suggestions that the European Financial Stability Facility could take the bonds and the losses ignore the impact on it! The EFSF which is my “unstable lifeboat” has troubles enough of its own. Giving it losses on a large scale might make it founder completely.
A problem for the ECB is that it lacks capital
The fact that the ECB lacks the capital to deal with the tasks facing it has been a regular theme of mine and I have returned to the subject from time to time to point out that if it were a private bank it would be insolvent. The official denials and bombast in response were inevitable but were followed by a plan to increase the ECB’s capital ( why if it is unnecessary …..?) and it has now risen to 6.36 billion Euros if we count members of the Euro.
There are various ways of calculating the losses from the Greek PSI plan but if we stick to the headline 50% number we see this. If you have 45 billion Euros of holdings then you lose 22.5 billion Euros which is inconvenient,to say the least, if your capital is less than a third of that!
If you use net present value calculations then it looks as if the losses over time (some losses are for now and some for the future) will head into the mid-60s in terms of percentages, and so as time goes by there will be extra losses. Even worse for the ECB.
There is a presentational problem here to say the least and we hit on one of the fundamental flaws of the construction of the ECB. It has backing from the various national central banks and the respective treasuries but the situation is not clear-cut. By contrast the UK taxpayer clearly backs the Bank of England and the US taxpayer backs the Federal Reserve.
What happens: The 8%/92% rule
An example of how this was never properly thought through comes from the fact that the rule given above was established in effect by a letter in November 2010 by the then head of the ECB Jean Claude Trichet. In my opinion he clearly exceeded his authority but as he was dealing with a group of people who as the group Sweet’s song Blockbuster pointed out in a rather prescient lyric.
Does anyone know the way? Did we hear someone say
We just haven’t got a clue what to do
Does anyone know the way? There’s got to be a way
It seems to have survived unchallenged. So now we have an estimated 22.5 billion Euros of losses initially which would be split 1.8 billion Euros to the ECB and 20.7 billion Euros passed down to the 17 national central banks (and eventually their taxpayers).
With one bound they are free?
Not quite as this ruse may get the ECB out of jail free so to speak but if we look at the impact we see quite a few troubled countries receiving losses. For example the Bank of Greece would get 2.8% of the losses, and the Bank of Portugal would get 2.5% of them. Two countries which plainly do not have any money get losses and in some ways even worse those on the edge get them too, so they are made weaker. The Bank of Spain would receive losses of over 2 billion Euros and the Bank of Italy would receive over 3 billion Euros. That is before the wailing and gnashing of teeth that would come out of the German Bundes bank as it imagines trying to defend how it allowed around 5 billion Euros of losses to become its responsibility at the German Constitutional Court.
A “nice little earner” for the ECB
Whilst capital losses are a problem for the ECB it does have money coming in on a substantial scale. As its money market programmes are now so large at round 850 billion Euros even an interest-rate of 1% gives it 8.5 billion euros a year. It pays a lower rate on deposits with it and of course amounts vary but even allowing for the deposit payouts it looks likely to earn more than 6 billion Euros a year (h/t Lorcan RK for drawing my attention to this).
Before the hard-pressed Euro zone taxpayer lets out too much of a cheer at this please remember there is a catch. All of the dodgy collateral that it has taken on board leaves us with plenty of potential for a familiar theme, interest profits accompanied by (usually larger) capital losses. But,of course, the kicking the can strategy involves kicking the losses onto someone else’s watch…..
There has been a debate over whether Greece now has a primary budget surplus. Those willing to project forwards on the basis of provisional, incomplete numbers from the Ministry of Finance which have not coincided in the past with numbers from other bodies are “sure” she has one.
For myself I was struck (looking at the confirmed figures which only go up to the third quarter of 2011) by an example of complete and utter failure. The bailout of Greece was badged as reducing her debt costs and instead they have surged.