16th January 2012
Markets open today in Europe following a slew of credit rating downgrades from Standard and Poors late on Friday night. Truly was Friday the 13th unlucky for the Euro zone as nine out of its 17 constituent nations received a downgrade. However in a metaphor for credit rating agency behaviour the actual announcement came an hour or so later than promised! This reminded me of their habit of mostly behaving with 20/20 and sometimes even 40/20 hindsight. Also whilst the media storm from the downgrades may well continue let us also recall two significant points.
Credit Rating Agencies deserve a downgrade themselves
Before we let credit ratings agencies become some sort of ultimate arbiter it is important to remember that their failure to correctly rate US mortgage bonds was a major cause of the credit crunch. In a more logical world they would now be less important now and been the subject of fundamental reform rather than having if anything a more important role. In essence they survive because we have failed to come up with anything better.
Also Standard and Poors is one of three credit ratings agencies so whilst its opinion’s do count there are two others before one comes up with some sort of “final score”. Many measures are based on an average of the three main agencies so on Friday one-third of the average changed not all of it for the nations concerned.
An accident of timing?
I do not think so as these acts by ratings agencies seem to be happening to a theme and a plan rather than just be coincidence. A type of “ratings war”? Perhaps but the consequences of a battle between the Euro zone and the ratings agencies is likely to be a lot of collateral damage. Indeed this action by Standard and Poors came as several Euro zone government bond markets were improving which adds a little more grist to the mill.
However the economic analysis provided by a ratings agency is often accurate if somewhat tardy so let us take a look.
Standard and Poors view of the nine downgraded Euro zone nations
Actually S&P has come around to my view that austerity as implemented in the Euro zone is leading to a vicious circle of economic failure for the countries concerned:
'As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.'
Nice of you to (belatedly) join the club S&P! Indeed they have joined my view of a two-speed Euro zone just as I have moved onto a three-speed one (The Three Euros)!
'In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the EMU’s core and the so-called “periphery”.'
As I pointed out last week the Euro zone core now comprises only 3 nations, and some of you replied with concerns about one of them (Finland). And then there were two?
The Euro zone “rescue lifeboat” the European Financial Stability Facility is in even more trouble
The S&P downgrades described above mostly affected countries where their government bond prices and yields had already mostly adjusted to its description of their problems. Those looking for a response today will find that the European Central Bank has been buying some of these government bonds to try to prevent one.
However one institution is left with a big problem and it is the EFSF. This has the fundamental problem I described back on October 27th 2010.
The EFSF has no money and has to go and borrow it. So now it is going to leverage money it has not even borrowed yet! What if it has to pay a high rate of interest or finds itself unable to borrow then the whole pack of cards falls down but this time it falls down times four.
Yes the EFSF always had the problem that credit downgrades of any of the 17 constituent nations would lead to a downgrade of it. As it has no capital it would be affected immediately as it has no buffer to help it out in difficult times. Even worse as the quote above highlights such a vulnerable institution was (out of desperation) planned to be leveraged four times! Personally I think the risk increased by four squared when this happened rather than by four times. Either way this hapless and indeed stupid plan was reined back to maybe leverage of once and in fact the whole leverage concept is mired in uncertainty.
Let us look at the problematic funding of the EFSF
Here we see that the EFSF claims it has guarantees from its constituent nations of 780 billion Euros. Further down its documentation (where presumably it hopes we wont read) we see that as Greece, Ireland and Portugal have “stepped out” so now we are down to 726 billion Euros.
However we see that Italy and Spain are responsible for.
Italy 132.5 billion Euros
Spain 92.5 billion Euros
Quite how they can manage this when they increasingly look like they will need a bail out themselves is not explained. But even worse we can see that two countries which were previously regarded as AAA by Standard and Poors are involved here too.
France 158.5 billion Euros
Austria 21.6 billion Euros
Not much left now is there? If we look at the remaining AAA rated nations we see that so much of the burden now falls on the Federal Republic of Germany. I have been arguing that this situation was likely for some time, but now rather than being an implicit problem for those who think about these issues it is beginning to be more explicitly displayed for many more to see. One sign of this is that Germany’s share (capital key) of the EFSF has risen from 27% to 29% as Greece,Ireland and Portugal have “stepped out”.
To my mind German taxpayers should have genuine fears about how much of this burden they might have to support. There are a growing number of scenarios where the likely burden becomes so heavy that even Germany will lose its AAA status. Should this happen then the EFSF becomes weaker and so some of the weaker Euro zone nations lose a possible prop and the circus carousel may make one more turn.
This is a very long way from the “shock and awe” instrument promised by Euro zone finance ministers such as Christine Lagarde back on May 10th 2010. Whatever happened to her by the way?
What can we expect next?
The EFSF itself will be downgraded and it will loose its AAA status. If we look at the markets we see that with the difficulties it has had in funding itself and its plans that they have already mostly adjusted to this reality. I suspect some will start to expect further downgrades as this pack of cards looks ever more suspect.
My image of it as an unstable lifeboat was brought to my mind by the Italian liner which hit the rocks over the weekend. Fortunately lifeboats of the nautical kind are usually well designed and were able to help. However (H/T Pawelmorski) we were left with the rather grim metaphor of an Italian liner foundering with French and German passengers! In such a financial emergency I expect that the EFSF will fail to help much and may even founder itself in a perversion of the concept of a lifeboat.
Greece and the debt haircut
As I reported on January 9th and 10th the talks on this ( also called private sector involvement) are going badly in fact very badly. This is a particular problem as Greece has a bond which matures on March 20th and she simply does not have the 14.4 billion Euros to repay it.
The best way to symb
olise it is that on January 10th I reported this.
"Greece has a one-year government bond yield of 372% and Germany has a one-year government bond yield of minus 0.03%. So there is a differential of just over 372%!"
And this morning I tweeted this on @notayesmansecon
"Greece has a one-year govt bond yield of 415.6% today which is some 415% over Germany! Currency Union anyone?"
So one measure is 43% higher and another might be the rather extraordinary amount of twitter action (re-tweets etc.) than have gone on in response to this message.
Meanwhile in Greece the news remains grim
From the Greek statistics agency Elstat.
'In September 2011 the total Building Activity (private-public), in the whole country-which is calculated on the basis of the number of issued in the whole country -amounted to 3,663 . This figure corresponds to 653.6 thousand m2 of surface and 2,397.6 thousand m of volume, reflecting respectively a 7.7 % decrease in the number ofbuilding permits, a 26.9 % decrease in surface and a 22.0 % decrease in volume, compared to themonth of 2010 (Table 1).'
Remember this is on the back of already depressed levels. As the Kaiser Chiefs put it.
And oh my god I can’t believe it