George Osborne, eat your heart out.
If you want to see really tough government spending cuts, you have to cross the Irish Sea. Yesterday, in its budget statement, the government doubled the size of the fiscal cuts it plans to make over the next four years, from €7.5bn to €15bn. And €6bn of that will be taken next year.
These are ambitious moves. As RBS put it, it certainly demonstrates that “Ireland is a serious country”.
Sadly, it might not be enough to prevent Ireland from needing a bail-out in the near future…
Why is the eurozone suddenly less attractive?
The yields on Irish debt – and other peripheral countries – have been rising sharply over the past week or so.
The yield on Greek ten-year bonds is above 11%. Irish yields are now at a euro-era high of 7.7%, despite the tough talking at yesterday’s budget statement. Portugal is sitting on 6.6%.
And just to make everyone that little more jittery, Russia’s sovereign wealth funds have revealed that they are no longer allowed to invest in Ireland or Spain. Meanwhile, the Norwegian sovereign wealth fund – the world’s second-largest, managing $520bn (gosh, that’s almost as much as QE2) – has also said that Spanish debt is becoming less attractive.
What’s the problem here? We all knew the eurozone periphery was dodgy. But things had settled after the Greek crisis broke earlier this year. Between them, the eurozone, the International Monetary Fund and the European Central Bank put in place the European Stabilisation Mechanism – a €750bn bail-out fund. So why the sudden aversion now?
In a word – Germany. Understandably, German taxpayers are a bit peeved at the idea that they might have to write a blank cheque to bail out any country that decides to spend itself into a hole in the future. As German chancellor Angela Merkel put it: “We must keep in mind the feelings of our people, who have a justified desire to see that private investors are also on the hook, and not just taxpayers”.
And last week, she put her foot down. In return for agreeing to make the eurozone bail-out fund permanent from 2013, she pushed through a commitment to a “crisis resolution mechanism”. What worries investors is that this will include some method by which bondholders will have to share the pain with taxpayers if European countries need to be bailed out in future.
Of course, there’s nothing wrong with this in principle. It’s ridiculous that Greece was ever assumed to be as creditworthy as Germany in the first place. So it’s a good idea to make sure that investors realise that if they lend their money without considering who they’re giving it to, they’ll end up paying the consequences.
A ‘toxic’ sign has been put on the peripheral eurozone
The problem – as Ambrose Evans Pritchard pointed out earlier this week in The Telegraph – is the timing. If they’d thought of this when they set up European Monetary Union in the first place, it might have done a lot of good.
But doing it now, just as investors are already panicky, is equivalent to putting a big “toxic” sign over the peripheral countries. As long as investors could assume that these countries would be bailed out, there was always going to be someone desperate enough to have their head turned by a tasty-looking yield.
Not now. As Nigel Rendell of RBC Capital Markets put it, “if you take the view that the peripheral economies are more likely to default or face a debt restructuring, why would you want to risk investing in their bonds?”
Ireland could be at the centre of a new eurozone crisis
The good news is that Ireland doesn’t have to return to the markets to raise more money until 2011. The bad news is that this just looks like a case of delaying the pain. Stuart Thomson of Ignis Asset Management tells Bloomberg: “We have little doubt that Ireland’s fiscal position is unsustainable. At some point in the next two years, you will find they will be forced to borrow from the European Financial Stability Facility (EFSF).”
The EFSF is the €440bn centrepiece of the European bail-out package. Trouble is, as FT Alphaville points out, it’s not actually worth €440bn. It’s a long story, but due to the way the EFSF is built, the funds it has available are closer to around €250bn. And it’ll be expensive to borrow from. More to the point, it’s untested. As Tracy Alloway put it on FT Alphaville recently, “the potential for an EFSF request to trigger panic and contagion is there.”
What does all of this mean for investors? The potential for another Greek-style crisis – this time centred on Ireland – is very real. For now the euro is flying high, based on the strength of the German economy and the Fed’s ongoing attempts to trash the dollar.
But as Ambrose Evans-Pritchard points out in The Telegraph: “Any need for an Irish bail-out would put Portugal in instant jeopardy, as is already obvious from the latest surge in Portuguese yields.” And with two bail-outs on the cards, the next domino could be Spain. “The EU bail-out fund is a bluff that cannot safely be called.”
The euro might survive in the long run. But it’ll suffer some touch and go moments along the way. And with the Fed damaging the dollar, it’s just possible that sterling will be one of the better currencies to be invested in over the coming months.
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