Here comes “Financial Crisis Part II”, says Tim Price of PFP Wealth Management. The credit crisis was never really resolved. Huge state bail-outs instead saw all the debt transferred to the public sector. Last week, confidence in European governments’ ability to repay their debts reached a “tipping point”, says John Authers in the FT. That resulted in a global sell-off “as ugly as anything” seen since last spring.
A wave of risk aversion
Investors are concerned that countries on the European periphery, notably Greece, Portugal and Spain, will have trouble financing their huge budget deficits. Fear that this could result in one or more countries defaulting on their debts triggered a wave of risk aversion. Greece, with a budget deficit of almost 13% last year and an overall debt load hurtling towards 120% of GDP, failed to placate markets with the news that the European Commission had approved a plan to tackle the deficit. The spread (difference in yield) between German and Greek ten-year government bonds remains close to the recent record peak of almost 4%. With markets “baying for blood”, as Capital Economics puts it, Portugal and Spain were next in the spotlight.
Portugal, whose overall debt is set to hit 85% of GDP this year, recently raised its estimate for its 2009 budget deficit to 9.3% of GDP. Last week it failed to raise the e500m it had been aiming for in a debt auction. Ten-year spreads over German debt hit their highest level since March, while the cost of insuring its five-year debt against default (via credit default swaps) hit a record. And Spain’s plans for cutting its 11% budget deficit look as overoptimistic as Portugal’s.
In reaction, the euro has slumped to an eight-month low against the dollar. The FTSE fell 5% between Wednesday and Friday, and Spanish equities shed 6% on Thursday. Markets steadied early this week on hopes of a bail-out for Greece.
Locked in a debt trap
Now the good times (see below) are over, the periphery countries are stuck. They can’t cut interest rates to temper the downturn and can’t devalue the currency. The only way to restore competitiveness, bolster growth and get debt under control is through slashing wages. But this risks a “vicious downward spiral”, says Stephen King of HSBC in The Independent. Lower wages and prices imply lower tax receipts, even bigger budget deficits and debt loads, “and, perhaps, higher bond yields reflecting rising default risk” – in turn making the debt load even worse. Austerity and high unemployment risks social unrest. Greece has already “lost control of its streets before spending cuts have even begun”, says Ambrose Evans-Pritchard in The Sunday Telegraph. The latest strike was planned for Wednesday. Meanwhile, Spanish unemployment is at 19%, so it’s hard to see Spain enduring much more. No wonder investors are “skeptical of governments’ ability to hit deficit reduction targets”, says Nick Stamenkovic of RIA Capital Markets. The “credibility gap” is largest with Greece but is growing in Spain and Portugal.
A Lehman replay?
It could soon be crunch time. A great deal of peripheral sovereign debt – 17% of the total in Spain, for instance – has to be rolled over this year, with Greece needing to refinance €20bn in the second quarter. “There are only so many times you can go to the well before people… say ‘there’s no price for this’,” says Gary Jenkins of Evolution Securities. We are “probably a [bond] issue away from finding out if that’s the case with Greece”. If the markets cut off funding and Greece can’t pay its bills, the default would push bond yields higher for other weak links in Europe, threatening to cause further defaults. “The world risks a replay of the Lehman collapse if this runs unchecked, this time involving sovereign dominoes,” says Evans-Pritchard.
The EU could calm the markets by outlining a clear plan for what happens when a state can’t refinance its debt, says Wolfgang Munchau in the FT. But so far it hasn’t come up with “a credible endgame”. It’s far from clear that northern Europe can afford to stand behind southern European debt, or that Germany will approve a rescue. If Greece alone is bailed out, the others will still come under attack. The markets are “testing the solidarity of monetary union”, says Jacques Cailloux of RBS.
The knock-on effects
If Greece becomes insolvent “and the value of its bonds collapse, European banks would have to take massive write-offs”, warns Commerzbank’s Joerg Kraemer. This “would tear yet more holes” in banks’ balance sheets and trigger another contraction of lending, squeezing growth, agrees Sean O’ Grady in The Independent. The “double-dip recession looks a lot more likely than it did a few weeks ago”.
Even without a collapse, falling prices for peripheral debt could dent banks and hamper growth. Germany and France’s exposure to debt from Portugal, Italy, Ireland, Greece and Spain comprises 22% and 32% of GDP respectively, says Morgan Stanley. Strains in the euro area are “unlikely to dissipate” fast, says the bank, which sees the euro falling to $1.24 by the year-end, from $1.37 now.
Europe’s problems “may be a dress rehearsal for what the UK and US face further down the road”, says Jim Reid of Deutsche Bank. Growth-crimping higher bond yields are on the cards as the focus on sovereign debt problems looks likely to endure. Britain has a “periphery-style problem”, says Ian Campbell of Breakingviews: “a weak government that is reluctant for both economic and political reasons to cut its huge deficit”.
Then there’s the unwinding of the global dollar carry trade, which has funded punts on everything from equities to emerging-market currencies and commodities. With the trade estimated at $1.4trn, a rapid jump in the dollar implies a quick exit by investors from the other side of the trade and the prospect of sharp falls in these markets. Worries over whether the global economy could suffer a relapse now simulus programmes are set to be removed won’t boost confidence. As Campbell says, “if fear persists, few global markets will be untouched”.
How the European periphery got into trouble
The eurozone periphery has too much debt and “too little credibility”, says Lex in the FT, but the “root problem” is a lack of competitiveness. Before the crunch, prices and wages rose, in many cases boosted by housing and credit bubbles that resulted from interest rates being too low when these countries joined the euro. As Edward Harrison notes on Seekingalpha.com, while painful restructuring meant that German labour costs actually fell slightly between 2000 and 2007, in Ireland, Spain and Portugal they jumped by 25%, 23% and 17% respectively. And in Greece the public-sector wage bill almost doubled between 2000 and 2008, according to Deutsche Bank. As competitiveness dwindled, trade deficits rose sharply, as did foreign borrowing. Barclays Capital estimates Spain’s net external debt at 91% of GDP (e950bn) and Portugal’s at 108% (208bn). The economic and credit boom papered over the cracks, but the lack of discipline is now taking a heavy toll.
Poor competitiveness means these countries will struggle to boost growth through exports – which, given that they have no control over their currency or interest rates, is the only route to growth open to them.
US unemployment hits postwar record
There was another reason for the ugly mood in markets last week: another set of lacklustre labour market figures in the world’s leading economy, the US. The unemployment rate ticked down from 10% to 9.7% and the working week increased marginally. But the overall picture is that unemployment has hit postwar records, while the recovery has been “worse-than-jobless”, says Martin Hutchinson of Breakingviews.com.
The dip in unemployment partly reflected discouraged workers leaving the labour force. Meanwhile, economists had pencilled in a rise in non-farm payrolls of 15,000 in January, yet 20,000 were lost, and sharp downward revisions to previous months’ figures meant that 1.2 million more people lost jobs in this downturn than previously estimated. That makes this recession four times more severe by this measure than the post-war average. Normally, employment is up by 100,000 a month two years after a recession begins, adds David Rosenberg of Gluskin Sheff.
A worry now is that the long-term unemployed (at least six months out of work) now make up an unprecedented 41% of all jobless workers. Overall employment of 129.5 million is at 1999 levels, yet the number of people competing for jobs is up by 29 million since then. The strong rebound in GDP in the fourth quarter couldn’t stop employment sliding, says Economist.com, so it bodes ill that growth is likely to ease as momentum in the labour market is dwindling. Initial jobless claims were up by 6% month-on-month in January. “The longer it takes to achieve steady job creation, the more uncertain recovery” becomes.