9th February 2010 by Shaun Richards
Yesterday saw more turmoil in world markets as the possible implications of the crisis which is building in the south of Europe worried investors. The so-called Pigs (Portugal,Ireland,Greece and Spain) came under yet more pressure. The yardstick of using German ten-year government bund yields as a benchmark gave us the following at last night’s close.
Greece +3.61%, Ireland+1.68%,Portugal +1.68% and Spain +1%
So the interest rate pain on government debt increased with Ireland rising the most by 0.1% closely followed by Greece 0.09% and Portugal 0.07% and Spain the least on 0.02%. However this is not a collapse more a drift and Spain may be heartened by the way her rates barely moved. If one excludes Greece then the other three countries have kept their government bond yields much more under control at the shorter end (up to two-year maturity). The reason why I take a look at this as a signal is that governments and monetary authorities are usually able to control shorter term rates and therefore rises in these are a clear sign of a loss of control and disarray.
Who might be next?
There is the usual talk that Italy will be next and on her National Debt to Gross Domestic Product (GDP) ratio she is a candidate. However my eyes fell on a chart last week (thank you FT) which showed the Euro zone and looked at both National Debt to GDP and fiscal deficit for this year. On such a chart France was almost superimposed on Portugal yet everyone appears to be talking of France as a rescuer not a rescuee.
Bail out talk
This has been heightened today by the news that Monsieur Trichet who is the Chairman of the European Central Bank is to leave Sydney in Australia a day early to attend a European economic summit with other European leaders. The actual agenda for this summit is to set a ten-year plan to strengthen European competitiveness (which sounds rather reminiscent to me of Joseph Stalin’s ten-year plans in Russia…..) but it seems that Greece may well be on the agenda now. Euro zone leaders have so far mainly stuck to the official line that Greece does not need help but I would suspect that a tape of their conversation on the 11th February would tell a different tale!
The problem in the Euro zone organising a bail out is that there is no mechanism for it. My advice is that they create one quickly. I was looking at a plan for a bail out yesterday and started to think of the flaws in it when it suddenly occurred to me that in some respects that they were not the real issue. In my experience authorities need to act quickly and decisively when they act and this is more important than the actual details of the plan. Once the situation has stabilised then the plan can be made more water-tight. Any decent plan operated quickly is more likely to succeed than a perfect plan operated after a delay. Of course Europe has already dithered and delayed. Indeed with the strikes planned for Greece on Wednesday perhaps this week is not the best time to act because of the potential moral hazard here of the strikers feeling that any move is a response to their behaviour. In my view the Euro zone should have already acted.
Also talk of a bail out is a weapon which has a finite lifespan like the boy who cried wolf. So if the European authorities are using talk as a weapon they are being foolish, I hope that they are not. Markets are very powerful and I remember working in a merchant bank treasury department when the UK was ejected from the Exchange Rate Mechanism in the early 1990s. Suddenly everyone was selling the £ including UK institutions and pension funds and it was a rout with the UK’s foreign exchange reserves which had seemed so substantial only the night before being depleted quickly. Markets are not a toy and this is not a game.
The short-term effect of a bail out will be to reduce credibility in the Euro zone. There is no way of avoiding this. However if decisive action is taken and the ECB is given the power to intervene in the future then it is not impossible that the Euro and Euro zone can emerge stronger. Even on this optimistic scenario there are questions about the Euro and crises going forward but it would be better equipped than it is now. In the short-term the fall in credibility may lead to further falls in the Euro exchange rate which many of the member countries would welcome, indeed the rise in it over the banking crisis period has contributed to where we are now. The Pigs cannot take such an exchange rate without much economic distress.
Observers of companies sometimes use guides such as the Chairman buying a Rolls Royce or the company building a new head office as warning signals, as in they are signs of hubris. The ECB is starting to build a new head office in April and it is expected to cost at least 500 million Euros. I will leave you to make up your own mind on this.
If we use the comparison with ten-year German bund yields as discussed above the UK is at +0.81% which was up 0.06% yesterday. We started 2010 with the differential at 0.61% so our comparative rate has hardened by 0.2% this year. So we are not in outright distress but with the amounts we need to borrow (the Debt Management Office estimates we will have to borrow £225.1 billion this year) any rise in yield is expensive.
What has caused this?
Our fiscal position where we estimate this year that our budget deficit will be some 12.6% of GDP is very poor and is the main cause. This will mean that our ratio of national debt to GDP will rise over the next few years. This has concerned markets.
We will also have to sell our UK government bonds on the open market this year as last year the Bank of England bought them all (actually it bought a little more than we issued). So markets have nudged our yields higher and are in my view probably waiting for our general election which is expected to be on May 6th before we can fully say what they think.
One card in our hand is that our currency can devalue and currently appears to be doing so against the dollar (although exchange rates are volatile). Often ignored in our economic debate is the effect of the fall in our exchange rate in 2007/08 which boosted our economy but also contributed to our rise in inflation. Without it our economy would be in a more serious state. Please remember to ask any proponent of us joining the Euro if you meet them today to estimate what situation our economy would now be in if we had joined and had been unable to devalue.