Austerity vs. money printing
The Eurozone crisis now appears to be centered on the battle between Germany and Greece – which can be characterised as the battle between austerity and growth (by which they really mean money printing). Last week this battle escalated further when Germany’s central bank, the Bundesbank, said it was prepared to kick Greece out of the Euro if it did not honour its commitment to austerity.
“When the Eurosystem provided Greece with large amounts of liquidity, it trusted that the programmes would be implemented and thereby ultimately assumed considerable risks… In the light of the current situation, it should not significantly increase these risks” said the bank.
Personally I doubt that Germany will kick Greece out of the euro. It’s not that Greece by itself poses a huge threat to economic stability, after all Greece only represents around 1.8% of Eurozone GDP, it’s that a Greek exit is likely to trigger a contagion.
The risk of contagion
As soon as Greece is out of the picture the international bond market would shift its focus to the “next worst” country, and Spain would likely be the top candidate. The Spanish economy – which is 4.6 times larger than that of Greece – continues to weaken and there currently isn’t enough money in the “firewall” pot to bailout Spain.
In addition to depression levels of unemployment, Spain also has an extremely fragile banking sector that is facing a capital shortfall of as much as $250 billion.
Trading in the struggling Spanish lender Bankia has been halted and the Financial Times reports that the Spanish government “is poised to invest up to 19bn euro in its most troubled lender… in a bold attempt to end market skepticism about the health of the country’s banking sector.” This comes just two weeks after the government injected €4.5 billion into the bank and took a 45% stake.
With Spanish 10-year bond yields already at 6.27% it seems unlikely that investors’ confidence will return anytime soon. Indeed Fitch ratings agency said 23 May that, “Foreign investors will keep cutting their holdings of Spanish and Italian public debt in coming months, reflecting a shift already seen in Ireland, Portugal and Greece.”
Holdings of Spanish debt by non-residents, excluding the European Central Bank, dropped in the first quarter of 2012 to 34% from 60% in 2008, while foreign ownership of Italian debt fell to 32% from 50% in 2008.
Spain’s Prime Minister, Mariano Rajoy, warned recently that rising borrowing costs were pushing his country towards the brink. “Europe has to come up with an answer because we can’t go on like this for long,” he said. Mr Rajoy blames the ECB for its failure to prevent a contagion by keeping a lid on bond yields.
It’s worth noting that Spanish and Italian bonds have a tendency to move up and down together, therefore an attack on Spanish bonds may well manifest as an attack on Italian bonds as well.
The pressure to act
The pressure to find a solution is on, and no one is feeling that pressure more than Germany’s Chancellor, Angela Merkel. Until now Mrs Merkel has vetoed the issuance of Eurobonds (debt investments issued by the Eurozone bloc as a whole), however her stance may now be changing.
According to a recent Bloomberg story, “While she refused to back joint euro-area bonds at a Brussels summit on May 23, Germany’s opposition parties wrung a concession from the chancellor on her return to Berlin yesterday to reconsider a separate proposal on common liability for sovereign debt.”
The proposal, which was published by Merkel’s council of economic advisers in November, involves a so-called European redemption fund that would help governments scale back outstanding debt to below 60% of GDP in return for constitutional commitments on economic reform. The government and opposition have agreed to study the proposed fund and discuss it further at the next meeting in Vienna, 11-13 June.
The price of failure
It has been estimated that to bailout both Spain and Italy would cost $3-4 trillion, and it is for this reason that I believe Germany and the other Eurozone nations will find a way to keep Greece in the euro. At least for now.