03/12 Spain on the Verge of a Nervous Breakdown

European leaders need to stop whinging and start solving their debt crisis for real.
BY EDWARD HUGH | DECEMBER 3, 2010

Europe’s debt crisis continues to spread — Greece and Ireland have already had to seek shelter from the European Union and the International Monetary Fund, while bond spreads in Portugal and Spain are giving strong indication they might meet the same fate in the not-too-distant future. And as the crisis develops, far from sending a much-needed signal of confidence and self-assurance, the rhetorical register we’re seeing from Europe’s leaders is becoming increasingly nerve-racked and even at times apocalyptic. In a typically troubling example, European Council President Herman Van Rompuy warned recently that the eurozone, and even the European Union itself, were in the process of fighting for their lives, telling the astonished audience at a Brussels think-tank conference, “We’re in a survival crisis.”

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More… Only a few days later, another top EU official, European Competition Commissioner Joaquín Almunia, stunned market observers with a statement that was widely interpreted as suggesting there might be something behind the rumors that Spain’s banking and government debt statistics were not as reliable as they should be. “There are no doubts that there is doubt [about Spain],” he said in an interview with a Spanish radio station, doubts that are connected with the possibility that Spain could “have something more than what it has already put on the table.”

Then, Olli Rehn, the European Union’s commissioner for economic and monetary affairs, tactlessly chose a day of extreme market tension to tell the world that in his considered opinion, the Spanish government was in danger of not complying with its 2011 deficit target of 6 percent. The result was predictable, and the next day yields on both Spanish and Italian bonds hit euro-era highs. The situation was brought under control only thanks to substantial intervention on the part of the European Central Bank (ECB), as well as bank President Jean-Claude Trichet’s promise of a major change in policy at the next meeting. As American economist Barry Eichengreen recently put it: “You can say one thing for the European Commission, the ECB and the German government: they never miss an opportunity to make things worse.”

Far from serving as a call to arms, comments like these, especially at such a sensitive moment in the latest round of the crisis, merely leave the people who make them looking ridiculous and trivialize the institutions they represent. The European Union itself is not in any kind of survival crisis. Indeed, the risk that the union will actually break up is so small as to be virtually nonexistent — and even though doubts remain about the long-term survival of the euro in its present form, this is not the immediate problem. The only meaningful way to ensure that the common currency survives in the long run is to find ways to adequately resolve Europe’s present problems. Wandering from the script, as Van Rompuy is wont to do, simply doesn’t help.

The problem Europe faces, as seen by the markets, is that it has half-emerged from one economic crisis only to be engulfed by another: the challenge of maintaining under reformed pension and health-care systems in the face of the most rapid population aging in human history, with very sharp increases in the elderly dependency ratio looming over the next 10 years. Add to this challenge the doubts about who is actually going to be responsible for whom: Will Irish citizens pay through taxes the losses incurred by Irish banks in the property bubble, or will the German government recapitalize the German banks that were irresponsible enough to lend the Irish the money to have the bubble in the first place? And at the heart of this sovereign-debt crisis is another tricky question: Whose sovereign goes with whose debt?

We are now into the third wave of the present crisis. The first tremors were effectively noticed around the turn of the year, when Abu Dhabi announced it was not going to take responsibility for all the excesses of its poorer but more reckless neighbor, Dubai. This news turned all eyes toward Greece and the issue of who was going to foot the bill for all that under-the-table deficit spending that had been going on since the euro was introduced.

Then in May came the second wave, when doubts about how the Greek crisis was being handled increasingly led investors to ask how many more countries on Europe’s periphery might be engaging in reckless deficit spending without credible plans to rein them in. The elephant in the room was Spain because while it is evident that Ireland’s and Portugal’s problems are more serious in the short term, Spain is without a doubt the most dangerous threat due to its size and the level of its private sector’s external indebtedness.

Last spring, a combination of well-timed crisis measures and good public relations were able to take the heat off Spain. What then followed could be called the long cool summer, as Spanish leaders grew increasingly relaxed and even almost nonchalant about their troubles. As Finance Minister Elena Salgado put it at the time, “I don’t have nightmares anymore.”

But the worst wasn’t over, and the sleepless nights must now be coming back because at the start of November a third wave broke out. Although most of the focus was initially on Ireland and Portugal, Spain and then Italy became increasingly drawn in via a process that financial analysts aptly call “contagion.”

But if the second wave was characterized by an obsession with the need for fiscal austerity — ruthlessly cutting budgets — this time the issue has broadened, with investors asking themselves and Europe’s leaders the awkward question as to how, amid all this austerity, these countries are ever going to be able to return their economies to growth. What worries investors is not the size of this year’s deficit, but the level of debt that will eventually exist and the extent to which this will be payable. To pay their debt (whether in the public or private sector), these countries need economic growth, and it is exactly here that Greece has come back to haunt everyone. Despite the sterling efforts the Greek government is making to keep to its fiscal-deficit targets, the economy is contracting so fast there that the level of debt (as a percentage of GDP) is simply rising and rising.

So the Spanish government finds itself trapped. All it can do to please the markets is keep to its existing targets. But it is here we find a Catch-22 double bind because keeping to target means watching the economy continue to contract, which means that the level of debt will continue to rise. Worse, if there is no return to growth, then Spain’s 20 percent-plus unemployment rate will not come down, which means more nonperforming loans and eventually more bank bailouts. Spain is caught in a self-perpetuating loop, and investors know it.

Although it might be hard to believe given all those hair-raising quotes, what Europe’s leaders at the EU and national levels are in theory focusing their strategy on is maintaining confidence on the part of both investors and consumers.

Consumer confidence is much easier to count on if consumers know what is happening. Confidence-building exercises of the “together we can do it” kind don’t work if the man and woman on the street are continually being told by their government that the worst is over and that the country is on the verge of recovery. (“Let’s wait a few weeks and we will see them [the green shoots of economic recovery],” Salgado told journalists outside the Spanish parliament at the height of the May crisis.)

Spanish leaders have consistently failed to prepare the public to accept the difficult sacrifices that will be required to really break out of the crisis, so it is hardly surprising if some workers decide to go on strike when told they will now need to continue to work until they are 67, rather than stopping at the current retirement age of 65.

And the same goes for investors, and it is here that the problem has become particularly tricky. When Europe’s leaders are not busying themselves denouncing the very people they need to borrow money from as “speculators,” they seem to be giving them replies to questions they aren’t asking. Most savvy investors now understand that EU countries are involved in collective fiscal-adjustment programs to reduce their deficit level. Measures like extensions in the working life, reductions in government salaries, and increases in consumer taxes are now commonplace.

What investors have now moved on to ask is precisely how these programs are going to be able to stabilize debt-to-GDP levels if the most severely affected economies, such as Ireland, Greece, Portugal, and Spain, don’t return to sustainable GDP growth. They are worried less about fiscal adjustment in the short term and more about sustainability in the long term. But rather than taking this long-term view, EU governments are insisting on trying to restore confidence simply by convincing investors of their willingness to make painful sacrifices. What investors are interested in is getting their money back, with interest, rather than seeing their debtors pained and humiliated.

All this reminds me of a powerful scene from the recent box-office hit Buried, in which the poor victim of a gang of unscrupulous kidnappers, having been nailed into an underground coffin somewhere in the middle of an Iraqi desert, is persuaded to cut off his own finger, on camera and linked to the world via a mobile-phone connection, just before the roof falls in on him and he is finally entombed in sand.

What policymakers sometimes seem to forget is that investors, just like citizens, are stakeholders in the future of the country they invest in. Indeed, the more they invest, the greater the stake they have. In this sense, they are far more realistic than many of Europe’s leaders because they are fully aware that not all EU countries are going to be able to pay back everything they owe. What sparked the latest bout of market nervousness in Europe was German Chancellor Angela Merkel making clear that the German taxpayer wasn’t willing to keep funding heavily indebted countries indefinitely and that private lenders were going to be asked to share part of the cost by taking their share of the haircuts in any future restructuring process. Fine, the investor might respond, but that bitter pill would be easier to swallow if countries were able to show meaningful signs of being able to kick-start their economies back into sustainable growth and pay a bigger proportion of the currently outstanding debt.

Yet one by one the countries fall. Ireland is already following Greece along the path of accepting an EU-IMF rescue program, and last weekend an 85 billion euro financial-support package was finally agreed on. Portugal is continuing to insist that no support package is coming. Spain is busily denying it is even a candidate for a bailout, and even Belgium’s name is starting to be whispered nervously in online forums.

Clearly the European Union’s decision to make 85 billion euros available to Ireland is a positive one, whatever issues arise about how the money is to be spent and the draconian nature of some of the measures demanded. The decision will give Ireland and Greece more time to put their houses in order.

On the other hand, the average interest rate charged under the plan (estimated to be around 5.8 percent) only takes Irish five-year interest rates back to where they were on Nov. 2. The financial markets clearly wanted to see Germany give some kind of direct guarantee on Irish bank debt, but what they got was Germany and the European Union lending money to the Irish government so that Ireland could then guarantee the bank debt. This clearly leaves the extent of German commitment to the maintenance of the monetary union a rather open question, even though with the new package now in place, European finance ministers have essentially accepted a potentially enormous fiscal burden on behalf of their electorates. Greece, for example, will need to have all its debts refinanced continuously by its European partners for many years ahead, while the Irish loan is on a seven-and-a-half-year basis from the outset.

Nor does the European Central Bank’s policy posture make much sense. Having countries pay 5, 6, 7, or even 8 percent to finance their debt doesn’t seem like a credible plan. And simply asking countries to make large fiscal adjustments will only lead to sizable economic contractions (the Greek economy is set to shrink 4.2 percent this year, and with the latest round of cuts that have just been announced the situation will hardly be better in 2011). Standing back and watching one country after another pay such sizable interest charges doesn’t seem to be the best way to spark a recovery.

And it is not only the “what” that lies behind Europe’s action plan that is disturbing observers. The “how” is also far from convincing. According to one popular metaphor, the eurozone is now like 16 Alpine climbers scaling the Matterhorn who find themselves tightly roped together in appalling weather conditions. One climber — Greece — lost his footing and slipped over the edge of a dangerous precipice. As things stand, the other 15 can easily take the strain of holding the Greeks dangling, however uncomfortable it may be for them. But others are starting to slide. Ireland has now slipped over the edge, while Portugal is moving even closer by the day. Just behind comes Spain, and somewhere further back Belgium. If all three finally go over, this will leave 11 countries supporting five, something that the May bailout package only expected as the worst-case scenario, and placing a strain on those remaining that might prove impossible to withstand. Italy in particular comes to mind.

Winning the battle to come will require two things. First, a clear response is needed at the national level, and in particular from the Spanish administration, because in many ways, given its sheer size, the future of Spain will determine the future of the rest.

And it is not only a question of additional measures. To convince financial markets, Spain’s leaders must find a credible plan for returning their economy to growth. Presently, growth forecasts for the Spanish economy are being revised down, by the European Union from 0.8 percent to 0.7 percent for next year.

The markets also need evidence from Brussels and Frankfurt that those responsible for decision-making at the highest level fully understand the dimensions of the problem and are willing to do whatever it takes without putting limitations on areas of action in advance.

Letting the European Central Bank buy national bonds in the primary markets and issuing EU bonds would be two possible ways to move forward. Beyond that, Europe’s leaders must instill in their citizens the message that we either are all in this together or will surely all hang separately. Rather than another bout of frivolous and inopportune comments from Van Rompuy, what we really need from Europe’s leaders is a demonstration of calm and determination coupled with a large dose of courage and imagination.

It looks clear that things are set to get a lot worse before they get better. In fact, such deterioration might be the only thing that will knock the various national heads together because as we can see, the long slow process of developing the policy tools needed to get to grips with the problems took one lurch forward under the impact of last May’s surge in sovereign bond yields and the latest round of pressure is producing another one. So despair not. Remedies are there, and they can be applied when the will to do so can be found. Until then, let’s just hope the ropes hold.

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About Uy Do

Banking System Analyst, former NTT data Global Marketing Dept Senior Analyst, Banking System Risk Specialist, HR Specialist
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