6th September 2011 by Shaun Richards
Over the past few days the situation concerning Italy and its relationship with the rest of the Euro zone has deteriorated markedly. I discussed back on the 30th of August the way that Mr. Berlusconi’s government appeared to be backsliding on its promise to introduce 45 billion Euros of austerity measures. In essence the Italian government has cut back its tax raising plans and to balance this up has reduced its spending cuts too! As this matter will be debated at the Italian senate today we will find out more about how near or indeed how far the Italian government will be from its original target and promises. Just to indicate that it is under pressure from both sides there is a general strike in Italy today called by unions protesting against the measures being too harsh.
The European Central Bank replies
On Friday the President of the ECB gave an interview to Il Ore and expressed this view on Italy.
The Italian economy has tremendous potential given the quality of its human resources and its corporate culture. And yet economic growth has been disappointing. For this reason, I believe in particular that structural reforms are necessary to increase the growth potential of an economy held back by too many obstacles – and they prevent it from achieving its full potential.
He chose his words carefully but they are an attack on Italy and its economic progress and system. I covered Italy and her economic progress on the 11th and 12th of July for those who want a more detailed analysis of the Italian economic situation and the reasons behind Mr. Trichet’s words. However he did not stop there as he also pointed out this and the emphasis is mine.
These measures decided by the government in its announcement on 5 August are of extreme importance to rapidly reduce public finance deficits and enhance the flexibility of the Italian economy. It is therefore of the essence that the overall goal in terms of the public finance improvement that was announced be fully confirmed and substantiated. This is decisive to consolidate and reinforce the quality and the credibility of the Italian strategy and of the Italian signature.
It is unusual for the ECB to openly question the credibility of a government’s word. For example in the case of Greece quite a lot of misrepresentation has in effect been overlooked, but the same leeway is clearly not being given to Italy. Also we see the ECB reinforcing the message that it sent to Italy in early August which in a nutshell told it that more austerity was needed. Indeed some suspected that this message included a section which said that the ECB would support Italy’s bond market if Italy took what it considered to be sufficient action.
The ECB does indeed act
After a weekend of speculation about Italy’s position we received this information about the ECB’s bond purchases yesterday afternoon.
As the SMP transactions which settled last week were of a volume of EUR 13,305 million, the rounded settled amount – and the intended amount for absorption accordingly – increased to EUR 129.0 billion
At a time when much market attention had been elsewhere this doubling of the weekly purchases by the ECB I think caught some by surprise and accordingly it contributed to yesterdays unsettled markets. If we analyse it we can see that this posed several important issues.
1. As both Italian and Spanish government bond prices fell and yields rose last week how much more would the ECB have to buy to stabilise things?
2. Italian yields had in fact gone above their Spanish equivalents in spite of the fact that the ECB purchases were rumoured to be heavily weighted towards her, so how much would they rise left to their own devices?
3. In the previous interventions it has made the ECB has generally found itself able to wind them down over time but here it has had to increase it and worse than that yields still rose. So will it have to intervene on an even larger scale?
Those who have followed my discussion of the effect of this intervention on the ECB’s balance sheet will have food for thought in the size of this SMP (Securities Markets Programme) rising to 129 billion Euros. It represents a bigger and bigger risk as if we look at say Greece whose bonds represent a good proportion of the early purchases we see that the yield on her two-year bond went above 50% yesterday and her ten-year went above 19%. So there are heavy losses and as I pointed out on August the 30th some 92% of the SMP goes back to the national central banks. Just to reinforce the point these include Greece, Ireland, Portugal Spain and Italy. So their central banks are carrying heavier and heavier losses in a very odd type of rescue if rescue it is. I discussed the SMP and its problems in detail on the 23rd of August.
The ECB responds by default
Yesterday the ECB was rather eloquent by doing what Sir Humphrey Appleby described as “masterly inaction”. Whilst the Italian bond market was under pressure and her ten-year yield surged from 5.3% to 5.5% it did not intervene. I think here we got confirmation that as I pointed out earlier in this article the ECB had indeed intervened in the past as part of a pact that the Italian government would introduce a pre-arranged new austerity package.
I have regularly argued that bond purchases under the SMP were a tactical move that due to inaction and dithering by Euro zone politician’s has been forced to become a strategy. Indeed it is a metaphor for the credit crunch era where central banks have moved from tactics where they belong to strategies where in my opinion they do not. And in my view they have contributed to the mess. However if we look at the ECB and its SMP its governing council members may well have the Alan Parsons Project on repeat play.
I just can’t seem to get it right
Damned if I do
I’m damned if I don’t
As they face a choice between an expanding balance sheet of ever lower quality and higher losses and a possible collapse in some of the peripheral bond markets well may they hum it. In fact the second choice should be some more of the Euro zone bond markets as with the yields mentioned above Greece’s bond market has collapsed already.
Switzerland pegs her currency to the Euro
As I had pointed out only on Friday the even negative interest rates were not getting the job done for Switzerland in her efforts to weaken the Swiss Franc. So the Swiss authorities found themselves backed into a corner where unless they wanted to end up like the little boy who cried wolf they could not keep promising to peg the Swiss Franc against the Euro without at some point doing it. Today turned out to be the day as this from the Swiss National Bank indicates.
The Swiss National Bank (SNB) is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20. The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.
This has led to some extraordinary moves this morning as the Swiss Franc moved from 1.11 overnight towards this level and jumped from 1.26 to 1.34 versus sterling. As I type this it is some 7.7% up versus the US dollar.
So in the short term there are some successes here. Let me give you two that immediately come to mind. Those who borrowed in Swiss Francs in Eastern Europe will be relieved as will several governments who ended up having to cap their currency risk in an attempt to protect their national economies. The Swiss economy itself will find itself more competitive with exporters particularly benefiting.For more information on these subjects I have covered them many times but the 24th of May and the 10th of August articles in particular will help.
The Flaws in this
Only over the weekend I replied to a comment on this blog that currently we see that countries with every type of exchange rate system are currently unhappy be it fixed pegged or floating. Accordingly this is not a case of “with one bound he/she is free”. Indeed whilst there are short-term gains the situation could yet get worse for the following reasons.
1. Switzerland can indeed intervene in ” unlimited quantities” as she will be supplying her own currency and she can create as much as she likes of it and sell it. But she is raising her own money supply and may have to do so on a massive scale. That may seem fine now but what about the future and what about the implications for the SNB’s price stability mandate? (Indeed history is a guide here as a similar effort in 1978 was abandoned in 1981 as inflation rose to 7%)
2. One of the causes of this situation has been the carry trade which mostly took place in the middle of the last decade where both Swiss Francs and Japanese Yen were borrowed heavily in many countries. This depressed the currency then and its partial unwind is raising it now. So how is creating the conditions for it again going to help? You see one cause was low interest rates which, ahem, are now negative and the exchange rate has just been effectively pegged against the Euro reducing currency risk too!
So carry traders have an implicitly pegged exchange rate versus the Euro and negative interest rates in what one might consider to be a type of carry trade heaven!
3. If we consider those who are looking for a safe haven in these times Switzerland and her currency suddenly looks more attractive on two counts. Firstly the price for you has improved as it has fallen by 7/8% and secondly you have the SNB promising you as much as you would like! I have pointed out that some of the bigger traders would find the Swiss Franc more attractive if it was a bigger market. Well now it is…
4. What will Switzerland do with all the money that will pour in?
So there are some thoughts for you to consider. The darkest road is where the carry trade builds up in size again which in the short-term will help the SNB by putting downwards pressure on the Swiss franc and politician’s declare “success”. This could easily be followed a few years later by them expressing “surprise” at its sudden strength whenever the carry trade is unwound.
I will retrun to this subject in future updates but in the very short-term I have another thought for you. With a 7/8% move in a currency in a few hours the scenario where a hedge fund could collapse has just been created and we would be back on red alert again.