MacroScope

The law of diminishing returns?
The first euro zone bailout, of Greece, bought a few months of respite, the next ones bought weeks, latterly it was days. Now … hours. Spanish bond yields ended higher on the day and, more worryingly, Italy’s 10-year broke above six percent. It was always unlikely the deal to revive Spanish banks was going to lead to a durable market rally with make-or-break Greek elections looming on Sunday but there were other things at play.

Top of the list is that the bailout will inflate Spain’s public debt and the dangerous loop of damaged banks buying Spanish government bonds that are falling in value. There’s also the fact that Germany and others are keen to use the new ESM rescue fund to funnel money to Spain because of the greater flexibility it offers. That will make private investors subordinate to the ESM which could prompt another rush for the exits which Madrid can ill afford since this is the first euro zone bailout which keeps the recipient active in the bond market.
It’s for the same reason that a revival of the ECB’s bond-buying programme, which it still doesn’t fancy, could prove counter-productive.

Officials are already pondering that conundrum, suggesting that the loan to Spain could initially be made under the existing EFSF bailout fund then taken over by the ESM, though that sounds like the sort of creative thinking in Brussels that generally fails to convince investors.
Another cracking Retuers exclusive following our breaking of the Spanish bailout on Friday, showing European finance officials have discussed limiting the size of withdrawals from ATM machines, imposing border checks and introducing euro zone capital controls as a worst-case scenario should Athens decide to leave the euro, is unlikely to have settle market nerves.

Today, the ECB releases its bi-annual report on risks facing the financial system. I’d imagine it will have a fair amount to say. For now, it seems content to let governments take all the strain of crisis management. Plenty of policymakers, Hollande, Merkel, Monti and Van Rompuy included, are speaking today but having done their bit for Spain over the weekend it’s really eyes down for the Greek election now, swiftly followed by a G20 summit and a key gathering of EU leaders at the end of the month.
There, some light will be shed on longer-term plans to make the euro zone a more durable economic union, although this is going to be a long haul – too late to address the current crisis. We’re expecting French and German briefings today, the latter on the Los Cabos G20.

There’s also a groundswell behind setting up a banking union, including a deposit guarantee fund, quickly. European Commission chief Jose Manuel Barroso, ECB policymaker Christian Noyer and French Finance Minister Pierre Moscovici are all espousing it today. Germany, where the bill will fall, is much more reticent and wants to see the drive to fiscal union, which will take many months even years of negotiation, treaty change and parliamentary ratifications, completed first.

100 billion used to be a big number. These days, it barely buys you a little time.

Euro zone finance ministers agreed on Saturday to lend Spain up to 100 billion euros ($125 billion) to shore up its ailing banks and Madrid said it would specify precisely how much it needs once independent audits report in just over a week. 

A bailout for Spain’s banks, struggling with bad debts since a property bubble burst, would make it the fourth country to seek assistance since the region’s debt crisis began, after Greece, Ireland and Portugal.

Spain’s plans to revive Bankia with state money and sort out its regions’ finances have well and truly unnerved the markets. It seems that Plan A — to inject state bonds straight into the stricken bank so that it could offer them to the ECB as collateral in return for cash — was roundly rejectd by the European Central Bank, so Madrid rapidly produced a second plan which will involve the government raising yet more money on the bond market, not helpful to its drive to cut debt.

That leaves the impression that Spain is making up policy on the hoof, not something likely to endear it to the markets. That’s particularly unfortunate since it has actually done an awful lot on the austerity and structural reform front over the past two years. But not enough.

It’s not all one-way traffic. Madrid is pressing its insistence that the ECB should be the institution to deliver a decisive message to the markets that the euro is here to stay – presumably by reviving its bond-buying programme (highly unlikely at this stage).

The ying.
Sources told us last night that Spain may recapitalize stricken Bankia with government bonds in return for shares in the bank. That would presumably involve an up-front hit for Spain’s public finances (it is already striving to lop about 6 percentage points off its budget deficit in two years) which might be recouped at some point if the shares don’t disappear through the floor.
The ECB’s view of this will be crucial since the plan seems to involve the bank depositing the new bonds with the ECB as collateral in return for cash. If it cries foul, where would that leave Madrid?

Spain’s main advantage up to now – that it had issued well over half the debt it needs to this year – may already have evaporated after the government revealed that the publicly stated figure for maturing debt of the autonomous regions of 8 billion euros for this year is in fact more like 36 billion. Catalonia said late last week that it needed central government help to refinance its debt.  If more bonds are required to cover some or all of Bankia’s 19 billion euros bailout, Spain’s funding challenge in the second half of the year starts to look very daunting indeed.

The yang.
Latest Greek opinion polls, five of them, show the pro-bailout New Democracy have regained the lead ahead of June 17 elections although their advantage is a very slender one. If the party manages to hold first place, and secures the 50 parliamentary seat bonus that comes with it, then it looks like it would have the numbers to form a government with socialist PASOK which would keep the bailout programme on the road … for a while.

After last week’s hefty losses, European stock gained yesterday and are up up again this morning, denoting some optimism about the Wednesday supper summit of EU leaders, which might well be unrealistic.

The European growth measures that we know are in the works – boosting the paid-in capital of the European Investment Bank and plans for ‘project bonds’ underwritten by the EU budget to finance infrastructure – might help a little but will fall a long way short of turning the euro zone economy around, so unless we get something more, on either the growth or the building defences fronts, there’s scope for investor disappointment.

Europe’s international partners continue to demand more dramatic crisis action. After the G8 summit, President Obama was out last night with four demands:
- firewalls to protect countries from Greek contagion (are the ESM and IMF funds now viewed as insufficient?),
- recapitalization of banks that need it (Spain to the fore here presumably),
- A growth strategy to run alongside tight fiscal measures (easier said than done),
- easy monetary policy to help the likes of Italy and Spain keep cutting debt (the ECB thinks its 1 percent rate is very loose and is unlikely to cut soon with inflation above target and will only flood the system with more liquidity in utter extremis)

What happens if Greece leaves the euro? No one can say for sure. But John Davies at WestLB, finds it difficult to envision a benign outcome.

Greece’s economy, at around $300 billion, is very small compared to the euro zone as a whole. The problem is if other countries follow suit – or are pressured in that direction by stubborn financial markets.

Such a scenario doesn’t bear thinking about because it is so horrible.

There is a good chance that the market would immediately trade Portugal towards pre-debt swap Greece levels. The next in line would certainly be Ireland and Spain.

We will return on Monday knowing whether the Greeks have elected a pro-bailout government and probably to find socialist Francois Hollande – the man leading the growth strategy charge – as the new French president. 

An Hollande victory could cause some jitters given his rhetoric about the world of finance. But we’ve looked at this pretty forensically and there may not be much to scare the horses. Yes he is making growth a priority (but even the IMF is saying that’s a good idea) yet his only fiscal shift is to aim to balance the budget a year later than incumbent Nicolas Sarkozy would. Contrary to some reports, he is not intent on ripping up the EU’s fiscal pact and of course the bond market will only allow so much leeway.

The heavyweight Economist magazine may have labelled socialist Hollande “dangerous” but the reality is likely to be that he will rule from the centre and his demands for a dash for growth — and a change to the ECB’s mandate to aid it — will be tempered. Spain has shown everybody that too much fiscal loosening will be pounced upon by the bond market and while there is a lot of talk about a growth strategy for Europe, what we’ve heard so far amounts to tinkering.

After a May Day holiday lull, the euro zone roars back into life with Spain facing a game of chicken with the bond market as it auctions three- and five-year bonds and the ECB holding its monthly policy meeting in Barcelona, which lends it a certain poignancy.

Spanish yields will rise sharply compared with the previous equivalent sale and the auction is the first since S&P’s two-notch downgrade of Spain’s credit rating last week. Spanish banks, flush with three-year cash despite their horrendous bad loans problem, continued to load up on Spanish government debt in March while international investors backed off. Whether they will continue to do so is a very open question.

Three- and five-year yields on the secondary market are more than a percentage point higher than when this maturity was last sold earlier in the year. But 2.5 billion euros is a modest amount to shift and Spain has already sold half its debt issuance target for the year in the first four months.

Spain has become the latest European country to slip into recession joining the Belgium, Cyprus, The Czech Republic, Denmark, Greece, Italy, The Netherlands, Ireland, Portugal, Slovenia and the United Kingdom.

Click here to view an interactive map.

*Updated to include Romania and Bulgaria

Steps forward and steps back…

The Netherlands’ fractured political class managed to unite enough last night to reach a deal on a 2013 budget which they say will cut the deficit to 3 percent of GDP as required by new EU fiscal rules. Failure could have undermined the EU fiscal pact before it was even born and undermined the efforts of Italy and Spain to pull clear of the debt supernova.

Shortly afterwards, Standard & Poor’s  put the boot in by downgrading Spain two notches to BBB+, saying it could cut the rating further. Most tellingly, it cited the increasing likelihood that the government will have to provide further funds to the banking sector which is beset by property bad debts. Madrid insists it will not have to do so, nor will it look to the euro zone for help. Something will have to give since there is no prospect of troubled banks raising capital themselves.

However, S&P did note the structural reforms already undertaken which should support growth in the long-term and the fact that the ECB’s three-year money operation had reduced the banking risk for now.