What will become of Spain’s economy and the Eurozone? What will it mean for Australia if Europe does fracture in the coming weeks? We’ll seek to answer those questions, and more, in today’s Markets and Money.
By the way, we’re taking the reins from regular DR editor Dan Denning for the next few weeks. Dan’s currently in Vancouver presenting at Agora’s annual symposium. Dan will be mixing it with the likes of economic historian Niall Ferguson, Marc Faber and Doug Casey. We’re sure he’ll have some worthwhile stories to share upon his return.
By the time he gets back, the financial world could look decidedly different. We are but weeks away from the Spanish economy losing access to capital markets entirely. Overnight, yields on all government debt maturities shot up to extreme levels. The 10-year yield hit a peak of 7.56%. The two year bond yield jumped a huge 100 basis points to a peak of 6.74%, indicating investors have no faith in the European Central Bank’s (ECB) efforts to calm markets (via its Long Term Refinancing Operation — LTRO).
Before the recent sharp spike in yields, the International Monetary Fund (IMF) forecast Spanish debt-to-GDP to hit 96% next year, up from 84% this year. This is some deterioration. The terrible equation of ‘debt dynamics’ for Spain’s economy consists of starting with the current debt-to-GDP ratio. You then add economic growth, the budget surplus or deficit and subtract the yield on 10-year bonds to work out whether the ratio is improving or deteriorating.
When economic growth is negative, the budget is in deficit, and 10-year yields are north of 7%, Spain’s debt-to-GDP ratio is clearly deteriorating. And with the Spanish government on the hook for its insolvent banks and insolvent regional governments, it’s only going to get worse. That’s why capital markets are shutting off access to funding, and why another bailout for Spain is on its way.
So where to for Europe from here? At last month’s summit, Europe’s leaders tried to come up with a solution to break the nexus between bank debt and sovereign government debt. It was an attempt to use bailout money (largely contributed by Germany) to recapitalise the banks directly, and buy government debt directly. The current bailout process involves loaning money to the government in question, effectively increasing its debt (albeit at a lower cost than otherwise would be available) to help it get out of debt.
Sounds insane right? It is. But there is where politics and finance meet head on. The nexus between banks and sovereigns is a crucial one for the modern welfare state. Governments spend money to buy a short term stay in power. Banks provide them with the money by buying government bonds.
This system can work smoothly for years, and indeed it has. But when debts become problematic and you don’t have your own central bank to print what you need (as is the case in Europe) it implodes. Right now, for Spain and soon Italy, the German government is the equivalent of their central bank. It’s the last source of money when everything else has run out.
But politics precludes the government acting like a real central bank. The German population will not stand for taking direct credit risk (and funding the apparently easier lifestyles) of its southern European neighbours.
This is why Germany blocked the deal agreed to at the June summit to directly recapitalise Spain’s banks with €100 billion. It will now be a loan to the Spanish government.
Europe kicked the can down the road in June but just a month later events have again caught up with it. Decision time is now approaching. Europe’s peripheral nations will exit the euro and turn to inflation to ‘save’ them or Germany will guarantee their debts.
The days of can-kicking and muddling through are over. It’s decision time for Europe…jump or be pushed.
So what do the Spanish authorities do in the midst of this maelstrom? They ban short selling.
This happens in just about every crisis. It’s monotonous in its stupidity. We’re sure we’ve written this somewhere before, but every time we read about a ban on short selling we turn to the classic Once in Golconda, A True Drama of Wall Street 1920-1938
It tells the story of the US economy in 1932. It’s in a depression; the stock market is in free fall. An election is coming up.
‘Hoover and the republicans badly needed a scapegoat to blame for the general disaster. The one they found most readily at hand was Wall Street, and the particular aspect of Wall Street that they chose was that old bugaboo, short selling on the stock exchange.’
Short selling was a
‘prime political target then; and the more so because the defense of short selling, to the eternal frustration of its defenders, has to be based on more sophisticated and therefore less readily grasped concepts.’
What are these less readily grasped concepts?
‘…every short sale necessarily implies a later purchase by the short seller; thus short selling can be looked upon as creating a reservoir of potential buying power that will ultimately work not to depress the market but to buoy it. In the absence of short selling…stocks would tend to gyrate all the more wildly, increasing the risk to the unwary investor…all recorded efforts to forbid or severely restrict short selling on stock exchanges over extended periods – in Holland in the seventeenth century, in France in the eighteenth, in England in the nineteenth, in Germany at the opening of the twentieth – had ended in failure. The short sale like the earth worm is an unprepossessing object that plays a useful role.’
Bans on short selling don’t solve anything, so expect more volatility in Spanish bond and equity markets.
But presumably you don’t have your wealth tied up in Spain’s economy. So let’s focus on what it means for the Aussie market. In the short term, it could actually be positive. That’s because as capital flees Europe, it flows to safer places. The US equity and bond market is no doubt absorbing billions of dollars fleeing Europe.
You could argue the same thing is happening to Australia. Yields on 10-year government bonds are now 2.8%. And the turmoil in Europe this time around isn’t having the same impact on the big four banks funding requirements. This is probably because the ECB monetised so much of Europe’s bad debt via the LTRO earlier this year. It’s giving capital a second chance to flee the region.
So it’s heading to Australia…into government bonds, bank debt and any ‘defensive’ asset. As a net importer of capital, this is a welcome development. Foreign capital supports Australia’s current standard of living. Without it, things would look very different indeed. Spain’s economy is realising just how bad things can get when your creditors pull the plug.
For Australia, the threat of having our tab turned off seems absurd. But so did many things that are now coming to pass. At the tail end of 40-year paper money experiment, you have to expect the unexpected.
There are black swans flying all over the place.
for Markets and Money
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