“The markets are unimpressed, and that’s the most generous description,” says VTB Capital’s Neil MacKinnon. Eurozone leaders were hoping to restore market confidence early this week with the €85bn EU-IMF rescue package for Ireland. But investors barely drew breath before continuing to sell peripheral debt.
Yields on ten-year Spanish bonds rose to a fresh euro-era high. The cost of insuring Portuguese debt against default hit a new record. Contagion spread to Italy as ten-year bond yields rose by 0.2% on Monday alone. Markets, “like sharks, pick off the weak fish at the edge of the shoal and work their way into the core”, as Chris Watling of Longview Economics puts it. The euro has dropped to a two-month low below $1.30.
Why investors are still worried
This package probably won’t even ensure that the rot stops within Ireland. Ireland will be able to prop up its banks with €35bn and €50bn will go on the government’s financing needs. It also gets an extra year – until 2015 – to bring its budget deficit back below 2.75%.
But while this will “tide the country over in the short term”, says Buttonwood on Economist.com, it doesn’t solve the debt problem. The average interest rate on the money will be 5.8%, “still more than the country can afford”. And “since the economy is not going to grow at 5.8% a year”, the debt-to-GDP ratio will keep on rising. Even if the government’s optimistic growth forecasts pan out, merely servicing the national debt would devour 25% of tax revenues by 2014. Defaults are typical once this figure reaches 22%, according to Moody’s. Indeed, it is “inevitable” a few years down the track, says the Irish Independent.
Who’s next?
Portugal also looks unlikely to clamber out of its debt hole, as we noted last week. Its lacklustre growth, poor competitiveness and rapidly rising interest costs have convinced markets that it is next in line for a bail-out. Expect it to tap Europe for funds by spring “at the latest”, says Stuart Thomson of Ignis Asset management. In Spain, which is too big to save, the worry is that the cost of shoring up the banking sector, which was hit by the bursting of the property bubble, could overwhelm state finances. The economy also looks likely to slide into recession again next year. That will merely reinforce fears over exactly how much potential bad debt is still sitting on bank balance sheets.
Now the spotlight is on Italy, an economy 50% bigger than Spain’s. Italy resembles Portugal, says Irwin Stelzer in The Wall Street Journal. Competitiveness continues to slip. Productivity grew by just 3% in 1998-2008, compared to 22% in Germany. “Spaghetti-like red tape” stifles entrepreneurship. Recent political instability is also rattling business confidence. All this militates against future growth exceeding the 1% pencilled in for the next two years. But the overall public-debt pile is a towering 120% of GDP, compared to Portugal’s 85%. So the danger, says Stelzer, is that with growth slow and unlikely to improve, tax revenues “might fall short of covering IOUs”.
A European Stability Mechanism
The other main European event of the weekend also went down like “a lead balloon”, says Lex in the FT. That was the outline of a deal to ensure that as of 2013 any future bail-out will require bondholders to share the burden of insolvency through debt restructurings. One problem with this “European Stability Mechanism” is the lack of detail, notes Capital Economics.
But it also means that the risks of lending to financially stretched eurozone countries will increase in less than three years, “which is no time at all for many investors”, says Robert Peston on BBC.co.uk. So if the weaker members haven’t sorted their finances out by then, which is highly likely, their lives will get much harder. They “could be confronted with punitive borrowing terms, or even a strike by lenders”. In 2013 alone, Portugal, Italy and Spain have to refinance more than €165bn.
Europe’s banks look shaky
Another reason markets are rattled by talk of haircuts, says John Mauldin on Investorsinsight.com, is the huge sum Europe’s banking system has lent to the periphery. German, French and UK banks’ collective exposure to Spain, Portugal, Ireland and Greece is around $1.4trn. Indeed, the “real” motive behind the bail-outs so far, says Satyajit Das on Nakedcapitalism.com, is to prevent large losses to banks that could in turn trigger a Lehman-like systemic meltdown. The banks still look shaky. One European Commissioner has called for more EU-wide stress tests – and conceded that July’s stress tests were flawed, says Economist.com. (After all, the Irish banks passed them.) And Europe’s big banks are still short of capital compared to their US or British counterparts, says Peston.
As problems mount, the authorities are constantly scrambling to put out fires; “there is no proper framework [for stabilising] confidence”, says Ken Watret of BNP Paribas. So what’s the endgame? The eurozone now faces two radical options, as Wolfgang Munchau points out in the FT: fiscal union or break-up. Unlike any other monetary union in history, the single currency zone never had a single government with a single treasury to stand behind it. But rectifying this through closer political union would require Germany to cough up yet more money, something it would be loath to do. So the zone may start shedding members. But whatever happens, says Charles Grant of the Centre for Economic Reform, this “bloody mess” will be with us for years.