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Ashvin Pandurangi: The European Monetary Union is the world's first example of an aggregation of "sovereign" nation-states into a single entity of economic exchange. Although there are many similarities between the EMU and the political aggregation known as the "United States", the latter only consists of one truly "sovereign" political authority. The U.S. Constitution provides that it, along with federal law, is the "supreme law of the land" in practically every sphere, while the EU Constitution only allows EU law to trump the laws of member states when the latter have explicitly agreed for the EU to legislate in those spheres.
The EU, therefore, illustrates the world's first "emergent property" of nation-states acting as an economic (currency) collective, without a very significant fiscal/political centralization of authority. Dr. Steve Keen, a renowned "Post-Keynesian" economist, recently published a presentation discussing the fact that prominent research in Neo-Classical economics has actually undercut the entire edifice of Neo-Classical theory currently taught in schools. [Video of Lecture].
Essentially, the research shows beyond a doubt that market demand curves cannot be modeled by aggregating individual demand curves which are subject to the "Law of Demand" ("all else being equal", demand for a commodity falls when its price rises and vice versa). While this law may hold for an isolated individual to some extent, it becomes little more than a coincidence at the macro-economic scale. Instead, complexity theory teaches us that when economic agents are aggregated to the macro-scale, the new collective is governed by novel, non-linear rules and exhibits "emergent properties".
That's why speculative financial bubbles are even capable of endogenously occurring within a capitalist "free-market" economy. When the prices of U.S. and European real estate continued to escalate dramatically throughout the late 1990s and 2000s, demand did not fall off, but instead continued to climb as more irrational investors joined the ranks of an emergent herd. As mentioned above, the European nation-state herd is not quite like any other we have witnessed before, and "emergent behavior" is not necessarily a good thing for economic sustainability or productive growth.
The EU as a collective monetary union is the largest economy by nominal GDP in the world, exceeding the US by more than 10%. . It has been clear for some time that all of the EU's member states, while retaining political "sovereignty" and diverse economic sectors, have become committed to preserving the value of any and all public bonds denominated in Euros. On the surface, there are various stirs about Germany or France not supporting further bailouts, or about Greece refusing the conditions of such bailouts, but it is the IMF, ECB and major bondholders who actually guide the herd.
The new rules governing this herd can be summed up in two words - austerity and privatization (a.k.a. wealth extraction). While the response of U.S., China, Japan and others to the global financial crisis has been marked by increasing levels of government support/intervention in private economies, the EU as a collective has rapidly evolved to the stage of large cuts to expenditures that benefit large swaths of people and the wholesale privatization of public assets.
Greek Reforms Must Move Faster, PSI In The Works: IMF"The IMF said on Wednesday private sector involvement (PSI) was fundamental to a Greek bailout and urged Athens to move faster on fiscal and structural reforms to avoid a debt default."
Ashvin Pandurangi: Greece has now graduated from public "stabilization funds" managed by the IMF and ECB, to a plan for "PSI" that requires fast-acting "fiscal and structural reforms" (i.e. continued gutting of the public sector), which will no doubt be micro-managed by the IMF despite its name.
"...Fitch said it saw contraction at 4 percent in 2011, followed by a weak recovery next year. It said asset sales in 2011 appear feasible but the privatization plan will be increasingly challenging.
The Fund praised the recent creation of a privatization agency to help rake in a targeted 50 billion euros in proceeds until 2015, and said the target was ambitious but achievable."
Ashvin Pandurangi: Despite (because of) the ongoing "bailouts" and austerity in Greece, Fitch tells us that its economy is contracting, and while the PSI plan is a good one, the Greek people will have to try extra hard to sell their assets and meet "the target" (on their backs).
..."The conservative opposition has opposed the bailout plan, saying it stifles the economy, but supports some state selloffs. A public resentful with austerity has staged almost daily protests against the measures."
Ashvin Pandurangi: The Greek population becomes more disenchanted with their economic situation and proposed "solutions" with each passing day, but the so-called "conservative opposition" gradually comes to support the PSI plan, which is fundamentally very much the same as austerity. Now, Greece was the first to reveal the emergent behavior of the EMU collective, but it will by no means be the last. As we get closer to the collective's center, the need to privatize national assets and keep major bondholders afloat becomes even stronger.
When discussing the massive exposure of French banks to the sovereign debt of Spain and Italy, which has recently come under market pressure, Ilargi at The Automatic Earth writes the following:
Ilargi: "Paris will -need to- step in to try and save its financial institutions. The first steps in that direction are already being taken. The International Accounting Standards Board (IASB) has advised Europe to implement their International Financial Reporting Standard 9 (IFRS 9), which is nothing but a sly and underhanded mark to fantasy trick posing as a "standard". Think the US' FASB 157. Basically, IFRS 9 allows investors to hold assets at cost as long as they don't try and sell them. That Greek haircut which is being discussed shaves off as much as 60% of debt value. But they may still appear on the books at 100%."
Ashvin Pandurangi: The first step is to make sure that, if the inevitable does somehow occur and one of the PIIGS technically defaults on their obligations, the major European bondholders (banks and institutional funds) will at least maintain some value on their books through fraudulent accounting. At the same time, however, the banks will need to "raise capital". That can be done directly through fiscal bailouts by their home countries, but those would also be very counter-productive to the underlying issue in the EMU - excessive public debts and deficits.
The more likely behavior is what we have already seen for Greece, Ireland and Portugal - an IMF/ECB sponsored public bond purchasing commitment. Another reason for executing this now standard European tactic is to protect against the trigger of CDS contracts that were taken out as default insurance. This issue is something Ilargi has written about extensively (see The Derivatives Pressure Cooker and Credit Downgrade Swaps), and it can only grow in importance considering Italy's 120% Debt to GDP ratio and the fact its 10-year bond is about 3% rich to Germany's. .
The plans for austerity, of course, have been in the works for some time, and the Italian Prime Minister will now present the "package" for passage this Friday, instead of its originally scheduled date in August. From AP:
Italy To Bolster Austerity Plan, Pass It By Friday"Italy's finance minister says the government's package of austerity measures will be strengthened and passed in both houses by Friday.
Giulio Tremonti sought to reassure markets during a speech to a banker's association meeting in Rome that Italy would speed reforms and austerity measures that seek to balance the budget by 2014.
But he also said that the pressure on markets in recent days was not a problem "of a single country, but of the structure of Europe".
Ashvin Pandurangi: So, does anyone now think that Rome will not be submerged in extensive "privatization plans" in the near future? Perhaps a big fat "FOR SALE" sign will be stuck in the center of the Coliseum? It is, as Tremonti says, a function of "the structure of Europe". Personally, I would say that Europe has fully emerged as a monetary union, and it is now behaving as any collective of nation-states would. There is no "turning back", and there is no "sustainable" plan to keep the collective together.
There are only games, tricks, cons and "private sector involvement".
And, then, there's riots and revolutions.
Moody's puts U.S. ratings on review for downgrade
by Walter Brandimarte and Daniel Bases - Reuters
The United States may lose its top-notch credit rating in the next few weeks if lawmakers fail to increase the country's legal borrowing limit and the government misses debt payments, Moody's Investors Service warned on Wednesday.
Moody's is the first of the big-three credit rating agencies to place the United States' Aaa rating on review for a possible downgrade, meaning the agency is close to cutting the country's rating. Standard & Poor's placed the U.S. rating on negative outlook on April 18 which meant a downgrade is likely in 12-18 months. "They are worried they are having these ideological arguments while Rome burns," said Carl Kaufman, portfolio manager at Oster weis Capital Management in San Francisco.
A lower credit rating would cause havoc in financial markets around the world and increase borrowing costs for the government and businesses, further harming public finances and weighing on the economic recovery. In a statement, Moody's said it sees a "rising possibility that the statutory debt limit will not be raised on a timely basis, leading to a default on U.S. Treasury debt obligations."
Risks of a default on Treasuries, traditionally seen as the world's safest investment, have increased since the government reached its legal borrowing limit of $14.294 trillion on May 16. Congress has refused to raise the statutory borrowing limit until agreement is reached on cutting the fiscal deficit which was $1.29 trillion in the last fiscal year. The Treasury Department has said if the debt ceiling is not raised by August 2 it will have to start prioritizing payments.
Default Risk No Longer "De Minimis"
Moody's said the probability there will be a default on interest payments is low, but it is "no longer to be de minimis." "If the debt limit is raised again and a default avoided, the Aaa rating would likely be confirmed," Moody's said. "However, the outlook assigned at that time to the government bond rating would very likely be changed to negative at the conclusion of the review unless substantial and credible agreement is achieved on a budget that includes long-term deficit reduction," the firm said.
There is precedent for Moody's decision. In 1996 the firm put some issues of U.S. Treasury debt on watch for a downgrade when the White House and Congress failed to extend the government's debt ceiling. Moody's decision came after U.S. markets had closed on Wednesday but before Asian markets ramped up their activity. In the 24-hour currency markets the U.S. dollar index, which measures the greenback against a basket of trading partner currencies, had fallen earlier in the session and ended down 1.1 percent, marking the steepest one-day decline since early December.
"In the short-term, the dollar definitely has its problems. This ratings news sent the dollar tumbling. This is really not good," said Brian Dolan, chief strategist at Forex.com of Bedminster, New Jersey. "Moody's might be doing this based on the politics as much as the threat of default, because the politics have become so problematic.... Between this and (Ben) Bernanke talking about QE3, the dollar could be entering a new downward phase," he said.
The U.S. dollar fell on Wednesday after Federal Reserve Chairman Ben Bernanke said the central bank could inject more monetary stimulus into the U.S. economy. The currency fell to a record low against the Swiss franc. The greenback hit a trough of 0.8095 franc, on electronic trading platform EBS. In after-hours trade, U.S. stock futures dropped 4.8 points to 1307.20 following Moody's decision.
In addition, the credit ratings for institutions directly linked to the U.S. government were also put on review for a possible downgrade, including Fannie Mae, Freddie Mac, the Federal Home Loan banks and the Federal Farm Credit banks. The ramifications of a U.S. downgrade could also be felt in places such as Israel and Egypt.
Moody's says the specific bonds issued by these two governments which carry a U.S. government guarantee "were also placed on review for possible downgrade." Israel and Egypt issue bonds without Washington's guarantee, and presumably they would not be subject to the current situation. The Congress has routinely raised the nation's debt limit in the past. This time, however, negotiations seem to have stalled over the degree to which the fiscal deficit should be cut by raising taxes or cutting spending.
So far, Treasury Secretary Timothy Geithner has been able to resort to extraordinary measures to delay a debt default by at least August 2. Unlike Fitch, which promised to cut the U.S. ratings to "restricted default" after a few missed debt payments, Moody's has said it would downgrade the United States to the "Aa" range, still considered investment grade.
S&P official warns of pre-default US downgrade
by Charles Riley - CNNMoney
Senate Democrats and officials from leading business groups have been warned that the country's credit rating could be downgraded even before an interest payment is missed. An official with credit rating agency Standard & Poor's, addressing a private meeting, laid out a scenario in which the United States would lose its sterling credit rating if it paid interest on its debt but failed to meet other obligations, according to two people familiar with the discussion.
John Chambers, a managing director at credit rating agency Standard & Poor's, briefed Sen. Harry Reid and other lawmakers, as well as officials from the Financial Services Forum and U.S. Chamber of Commerce. As many as 20 Democratic senators attended the private meeting last week, one of the sources said. The warning counters the argument that the United States could keep its AAA rating so long as it made interest payments on the debt by prioritizing them above other bills.
Some members of Congress, primarily conservative Republicans, have made the case that eclipsing the Aug. 2 debt ceiling deadline would be merely disruptive, and not the economic calamity predicted by credible experts. A downgrade has the potential to roil markets, increase interest rates and drive up the government's cost of borrowing.
Chambers' comments reinforce the view of Federal Reserve Chairman Ben Bernanke, who suggested a downgrade was possible if the country only pays interest on the debt to bondholders. "It's possible that simply defaulting on our obligations to our citizens might be enough to create a downgrade in credit ratings and higher interest rates for us, which would be counterproductive, of course, since it makes the deficit worse," he said Wednesday.
Fitch Ratings Agency said it would put the country on "Ratings Watch Negative" in such a scenario. "Extensive payment arrears to suppliers of goods and services to the government ... would damage perceptions of U.S. sovereign creditworthiness and signal growing financial distress," the agency said in a recent report.
The public pressure on lawmakers to raise the debt ceiling was ratcheted up Wednesday when Moody's, the third major credit agency, said it would put the bond rating of the United States on review for possible downgrade. Steven Hess, lead analyst for the U.S. at Moody's, said in a statement to CNNMoney that it is unlikely Moody's will downgrade unless the U.S. defaults on its bonds.
Negotiations are set to resume Thursday at the White House after reaching what appeared to be a low point on Wednesday as House Majority Leader Eric Cantor and President Obama squared off over taxes and the size of a deal. Multiple sources, speaking on condition of anonymity, said Obama told the gathering that "this could bring my presidency down," referring to his pledge to veto any short-term extension of the debt ceiling. Sources say he vowed, "I will not yield on this."
US Rating Close to 'Junk': Independent Strategist
Moody's Rating Agency on Wednesday placed the U.S. triple-A rating on review for a downgrade in the coming weeks on mounting concern that lawmakers will fail to raise the debt limit. But one independent rating agency is going even further.
"The Weiss ratings is very close to downgrading the sovereign debt of the United States one more notch to a 'C-', which will put it just one notch above junk," Martin Weiss, President of Weiss Ratings told CNBC on Thursday.
In April, Weiss Ratings gave the U.S. sovereign debt rating a 'C'.
Moody's warning came as the White House and President Barack Obama are locked in tense negotiations to raise the $14.3 trillion debt ceiling by August 2 or risk a default. Fed chairman Ben Bernanke has told a U.S. House of Representatives panel that failure to increase the ceiling will immediately cut government spending by 40 percent.
Weiss believes a downgrade by the ratings agencies is long overdue, noting that the top-notch standard assigned to the U.S. is unfair to investors and savers as they are not compensated for the level of risks they were taking.
"(The United States) has a huge debt load compared to most other countries," he said."(It) has a very unstable economy over the last 10 years compared to most other countries." The U.S. debt-to-GDP (gross domestic product) ratio currently stands at over 90 percent.
"The only thing that's really holding up the US debt rating is a widespread international acceptance for US Treasury securities and nice strong liquid market. But even that might be coming into question," he added.
But he is hopeful for a last minute deal, pointing to how the failure to pass a bailout package three years ago sent markets into a tailspin, and forced Congress to eventually sign off on it.
"We might see a similar scenario here in the debt ceiling debate, a failure at first and then a desperate deal in the thirteenth hour to rescue the situation at the last minute," he said.
Americans' pessimism deepens as economic concerns rise: Reuters/Ipsos poll
by John Whitesides - Reuters
Americans are deeply pessimistic about the future as economic concerns rise and White House talks on raising the U.S. debt limit sputter, according to a Reuters/Ipsos poll released on Wednesday.
The number of Americans who believe the country is on the wrong track rose to 63 percent this month, up from 60 percent in June, with stubbornly high unemployment and prolonged gridlock in Washington dashing hopes of a swift economic recovery.
But voters do not appear to be holding President Barack Obama responsible for the problems so far. Obama's approval rating held relatively steady at 49 percent, down 1 percentage point from June. His approval rating among independents -- a group Obama needs to win re-election -- fell to 39 percent from 44 percent.
Obama's standing could deteriorate quickly if the economy does not begin to generate jobs and if Washington cannot show it is capable of solving problems, Ipsos pollster Julie Clark said. "If those things don't happen, Obama will be in for a real challenge in getting re-elected next year," Clark said.
Obama and Republicans have hit an impasse in negotiations to raise America's borrowing limit before the government runs out of money to pay all of its bills on August 2. That could force the government to try to prioritize its payments. Asked what bills the government should stop paying if the debt limit is not raised, 36 percent listed international creditors like banks and 12 percent listed government departments like agriculture and education.
The sputtering economy and high unemployment are certain to dominate the race for the White House in 2012, and the Republican candidates for the nomination to challenge Obama repeatedly have criticized his economic leadership.
In a head-to-head matchup of the two top declared Republican challengers, Mitt Romney easily leads Michele Bachmann, 40 percent to 23 percent, the poll found. Romney, a former governor of Massachusetts, leads most national polls of the Republican race but Bachmann, a U.S. representative from Minnesota, has made inroads with an appeal to Tea Party activists and social conservatives. Among independent voters only, Romney's lead is just 10 percent.
The poll found more than half of Americans believe the economy is the country's most pressing problem, the first time a public majority has put it at the top of the list since shortly after Obama took office in February 2009. The survey was taken after a weak jobs report last week showed the U.S. economy is recovering slower than expected. Unemployment rose slightly to 9.2 percent. "People aren't seeing the jobs that they want to see," Clark said. "One in five people say unemployment is the biggest problem, and there has been no improvement in that."
Talks between Obama and congressional leaders on raising the $14.3 trillion U.S. debt ceiling before an August 2 deadline also have made little progress. Officials have warned failure to raise the limit could derail the economic recovery and endanger the global financial system. "People are watching these talks and getting a real sense of gridlock and a sense of pessimism about anything getting accomplished in Washington," Clark said.
The number of people listing government spending and the deficit as the most important problem rose to 14 percent in July from 8 percent in October of last year. Republicans have insisted on spending cuts as part of any deal on raising the debt limit. Democrats want tax increases as part of the deal. The poll of 1,173 adults, including 989 registered voters, was taken on Friday through Monday and had a margin of error of 3 percentage points. Interviews were conducted on both land lines and cell phones, in either English or Spanish.
The Truth Behind Fannie And Freddie: Why The Government Didn't Make A Profit From The Bailout
by Bob Eisenbeis, Cumberland Advisors
A recent column by Allan Sloan and Doris Burke in The Washington Post claims that the distasteful financial bailout not only worked but also generated a profit for the government of at least $40 billion and perhaps as much as $100 billion.
Their conclusion is based on their working of the numbers, and the source of the so-called “profit” is the interest that the Fed has earned on the assets acquired through QE 1 and QE 2 and returned to the Treasury.
They estimate that a net $102 billion has been returned to the Treasury by the Fed in 2010 and indicate that as much as $85 billion more may be returned this year.
Unfortunately, the authors have played fast and loose with the numbers. They have ignored important unreported costs of the bailout and, most importantly, they have misrepresented the true nature of Federal Reserve transfers of earnings to the Treasury. Because of these problems, their analysis risks becoming part of revisionist history that obscures the true costs of the bailout to the taxpayer.
Their work is already being cited in the hearings on FOMC monetary policy of July 13, 2011. Let us try to put forth a more objective take on the numbers and the kinds of analysis that must be done to get a clearer picture of the true costs of the bailout.
Consider first the authors’ treatment of the costs associated with Freddie and Fannie, which they state is the source of the biggest costs of the bailout. They pull numbers from a CBO June 2, 2011 report stating that the government has injected $130 billion on net into those institutions. But this ignores other important costs also contained in that same CBO report.
Specifically, the CBO states that fair-market adjustments to the assets and liabilities of Freddie and Fannie expose another $187 billion in unrecognized losses that must be added to the expected costs of their failure. Additionally, the CBO also estimates that the value of projected government subsidies to Freddie and Fannie between 2012-2021 will add another $42 billion to the estimated costs, bringing the likely total to $359 billion. This is far in excess of the $130 billion put forward by the authors and is sufficient to generate a significant “loss” on the bailout. But there is more.
I don’t quibble with some of the other estimates except to note that the low-interest-rate environment that the Federal Reserve has engineered has been a clear subsidy to financial institutions. The value of that subsidy should be considered a cost, but doesn’t appear in anybody’s calculations. Then there is the value of the subsidized support provided through the discount window and other Fed emergency programs.
Nor do people consider the fact that institutions have been able to borrow in the Federal Funds market at a rate substantially below the 25-basis-point risk-free rate that can be earned by depositing those funds at the Federal Reserve. Banks are also receiving 25 basis points, risk free, on excess reserves held in deposit accounts at the Federal Reserve.
The real problem with the Sloan-Burke analysis, however, is in their treatment of the Federal Reserve’s excess revenues over costs that are transferred to the Treasury. They suggest that the assets purchased as part of QE 1 and QE 2 have generated additional “profits” of about $102 billion for 2010 and another estimated $55 billion for 2011.
As we have noted in previous commentaries, the peculiarities of government accounting conventions treat these transfers as revenue to the Treasury. Thus, the funds can also be counted towards reducing the deficit. Treating an interest expense as revenue when returned by the Fed to the Treasury is really an accounting shell game. Consider what the Fed has done. It has printed money by issuing one form of government debt, to purchase to purchase other forms of government debt, Treasuries and MBS from government-backed Freddie and Fannie.
The government (Treasury) pays interest to another government entity (Federal Reserve) on those assets, and when the funds are transferred back to the Treasury an expense is magically transformed into revenue.
If the Fed purchased those securities directly from the Treasury, which it is legally prohibited from doing, the Fed would be directly monetizing the debt. It is now indirectly monetizing the debt. The revenues from this activity are not profits, nor should they be considered a return on investment from the bailout. Rather they are simply an intergovernmental transfer that results from printing money.
If it were that easy to reduce the deficit, then the Fed could simply buy up as much debt as possible. The Treasury could then use the return of interest payments it makes to the Fed to reduce the deficit to zero. If a little works, then why not do a lot? It is like writing a check to your wife, and when she gifts it back, you count it as income. The process makes Bernie Madoff’s Ponzi scheme look like chump change.
Italy money supply plunge flashes red warning signals
by Ambrose Evans-Pritchard - Telegraph
Monetary experts are increasingly disturbed by the pace of money supply contraction in Italy and most recently France, fearing that it could prove a leading edge of a sharp economic slowdown over the winter.
"Real M1 deposits in Italy have fallen at an annual rate of 7pc over the last six months, faster than during the build-up to the great recession in 2008," said Simon Ward from Henderson Global Investors.
Such a dramatic contraction of M1 cash and overnight deposits typically heralds a slump six to 12 months later. Italy's economy is already vulnerable – industrial output fell 0.6pc in May, and the forward looking PMI surveys have dropped below the recession line. "What is disturbing is that the numbers in the core eurozone have started to deteriorate sharply as well. Central banks normally back-pedal or reverse policy when M1 starts to fall, so it is amazing that the European Central Bank went ahead with a rate rise this month," Mr Ward said.
Italy is not a high-debt nation. Italian households are frugal by Spanish and UK standards. However, Italy has a toxic trifecta of problems that affect long-term debt dynamics: a public debt stock of €1.8 trillion or 120pc of GDP; rising interest rates; and economic stagnation. It is the interplay of these elements that has set off flight from Italian bonds.
Italy has to roll over or raise €1 trillion over the next five years, with a big spike as soon as August. "Any new issuance will be above the average rate. That is the real cause of the destructive market action," said Paul Schofield from Cititgroup.
The Italian and Spanish bond markets stabilised yesterday after coming back from the brink. News that US bond fund Pimco has taken advantage of the sell-off to accumulate Italian debt cheaply helped restore calm. The IMF has endorsed Italy's €40bn austerity package, though the measures are "back-loaded" with most of the pain in 2013.
However, RBS said the eurozone storm is far from over. "We expect the crisis to continue deteriorating, and threaten to undermine the entire euro area as European policy-makers still misunderstand market dynamics. They show no sign of catching up with reality," said Jacques Cailloux, the bank's Europe economist.
Mr Cailloux said the EU's bail-out machinery (EFSF) must be increased to nearly €3.5 trillion in committed funds to staunch the crisis. This would give the authorities effective firepower of €2 trillion. "It is a lot of money but the euro is a big project. This is all about political appetite. The longer they wait, the worse it gets.."
A fund of this size would amount to 27pc of eurozone GDP. The effective lending power of the EFSF at the moment is just €255bn, and half of that will be needed for Greece, Ireland, and Portugal. Greece's problems took a further turn for the worse yesterday after Fitch downgraded the country by three notches to CCC.
RBS compares the euro crisis with exchange rate turmoil in East Asia in 1998, though the EMU effect has this time switched risk from devaluation to bond default. Eurozone borrowers face the same "reversal in confidence" after years of deceptively benign conditions.
Hopes that eurozone leaders would deliver a "big bang" solution at a summit on Friday have been dashed after German officials said Chancellor Angela Merkel may not attend. Finance mininster Wolfgang Schauble warned against a "hectic" response, a way of saying Berlin will not be bounced into a decision. There is stiff resistance in Mrs Merkel's coalition to steps that drag the country into a fiscal union where sovereign debts are shared. German officials are drawing up possible plans to allow the EFSF to lend to countries such as Greece so that it can buy back its bonds in the market at a discount.
However, Bundesbank chief Jens Weidmann issued a caustic critique of the plan."It has a high cost, limited use, and dangerous secondary effects. This discussion is going in the wrong direction," he said. He added that the ECB would not accept Greek bonds as collateral if Athens defaults. "It is not our job to finance insolvent banks, let alone countries," he said.
The real M1 data show countries are vulnerable. There have been sharp contractions in Austria and Belgium. The Netherlands and Germany are negative. The ECB believes sluggish money supply figures reflect the reduction of an "overhang of liquidity" left from before the crisis and are benign. The claim has raised eyebrows among monetarists.
Tim Congdon from International Monetary Research said the ECB had drifted away from monetary orthodoxy after the departure of Otmar Issing as chief economist in 2006, tolerating "crazy lurches" in the broad M3 money supply. "The ECB did not see the collapse in money growth in 2008 and the great recession that followed, and they are getting it wrong again."
Darkening Clouds: Irish Debt Downgraded as Euro Worries Spread
Just one week after downgrading Portuguese debt to junk status, the rating agency Moody's has slashed its rating of Irish debt. The move comes despite growing official anger in Europe at the power of the big three rating agencies. But a new aid package for Ireland, Moody's believes, may be unavoidable.
The European Union in recent days has indicated it is seeking ways to limit the amount of influence rating agencies have when it comes to evaluating sovereign debt. But Moody's on Tuesday made it clear it is unimpressed. The agency cut Ireland's credit rating to junk status on Tuesday and warned that the country, struggling under an immense load of debt, would likely need a second bailout. Moody's has also kept the outlook for Ireland negative, meaning that further downgrades are likely.
The move comes just a week after a similar Moody's downgrade for Portugal and as the European Union is struggling to put together a second bailout package for Greece. In addition, concerns about Italy's finances have rocked European markets this week. Collectively, the events have resulted in a rapid fall in the euro's value against the dollar. The European common currency is now at its lowest level against the dollar in four months.
"This is a disappointing development and it is completely at odds with the recent views of other rating agencies," the Irish Finance Ministry said in a statement. In contrast to Greece, Ireland has met the targets set for it when it received its €85 billion ($119 billion) bailout from the European Union and the International Monetary Fund (IMF) last November. The Irish economy, however, has been sluggish and tax revenues are struggling as a result.
'Oligopoly of the Rating Agencies'
In recent days, in response to Moody's downgrade of Portugal, several European officials had indicated a desire to reduce the power of rating agencies. "Europe can't allow three private US enterprises to destroy the euro," European Justice Commissioner Viviane Reding told the German daily Die Welt, in a reference to the so-called Big Three of Moody's, Fitch and Standard & Poor's -- though Fitch is majority owned by a French company and is based in both New York and London. Both Fitch and Standard & Poor's have so far refrained from downgrading Irish debt to junk status.
Reding's colleague, Internal Market Commissioner Michel Barnier, suggested that rating agencies should not be allowed to pass judgement on countries that receive international aid. And German Finance Minister Wolfgang Schäuble has said that it must be examined whether "the oligopoly of the rating agencies can be broken up." He added that "last week there was a notification from a rating agency related to Portugal that was generally met with total incomprehension."
Barnier told SPIEGEL this week that efforts are underway to break the ratings monopoly held by the three large rating agencies. "We will try to create a separate European rating agency ," he said. Such a project, however, faces several hurdles.
'Cork Bobbing on a Turbulent Ocean'
Much of the nervousness in the markets comes as a result of the European Union's halting efforts to put together a second bailout package for Greece. The country is thought to need some €100 billion or even more to remain solvent through 2014. But while Germany remains adamant that private investors must be involved in any additional aid package, the European Central Bank is opposed. There is concern that any agreement involving private investors swapping current bond holdings for new bonds with longer maturities could be viewed as a partial default. Indeed, earlier this month, Standard & Poor's indicated it would view such a move as a partial Greek insolvency.
Adding to the concern in Europe this week have been indications that investors have begun targeting Italy due to its enormous mountain of debt, which amounts to some 120 percent of the country's gross domestic product. The country has since stepped up efforts to pass a massive, €47 billion austerity package .
Ireland, for its part, insists that it has enough funding to meet its obligations through 2013. But Finance Minister Michael Noonan on Tuesday admitted on television that the country's situation remained tenuous. "Ireland," he said on state television, "is a cork bobbing on a very turbulent ocean at present."
EU declares war on ratings agencies as Ireland's rating gets junk status
by Ian Traynor - Guardian
EU commissioner Michel Barnier takes on the big three credit ratings agencies: Standard & Poor, Moody's and Fitch
Ireland yesterday became the third eurozone country to have its credit rating downgraded to junk status as Europe slid into a war it may struggle to win with international credit ratings agencies. It followed a week in which the agencies partly forced a shift in the EU response to the Greek sovereign debt crisis.
A week after slashing Portugal's status, Moody's cut Ireland's credit rating to junk and warned that the country would be likely to require a second bailout. The Irish government, which wants to return to debt markets in 2013 when its current EU-IMF bailout runs out, said the development was completely at odds with the recent views of other ratings agencies. "We are doing all that we can to put our house in order and the progress that we are making is there for all to see," the department of finance said in a statement.
The commissioner in charge of the EU's single market, French politician Michel Barnier, alternately sneered and threatened the three big agencies who dominate 90% of the ratings industry: Standard & Poor's, Moody's and Fitch. His remarks followed a broadside on Monday from fellow commissioner Viviane Reding, who said the ratings agencies' "cartel" should be "smashed up" as they were seeking to determine the fate of Europe and its single currency.
"We were surprised that the agencies would downgrade a country without any warning," Barnier said of last week's verdict from Moody's on Portugal, branding its debt junk and predicting the country was the new Greece. "You don't rate a country the same way you rate a company or a product. That's an issue. We're examining that issue."
Barnier said he would announce "stiff measures" in November aimed at taming the power of the agencies. They would be forced to justify their decisions by revealing the details of their analyses and criteria. Whether they were properly registered in Europe would also be scrutinised. "I want to have transparency regarding their methods, especially when they are rating countries," he said.
S&P concluded last week that Greece would be found to be in a form of default on its sovereign debt if its private creditors were involved in a new EU bailout, as is planned. That verdict helped to trigger the rescue rethink announced over the past 48 hours in Brussels.
Christine Lagarde, the new IMF chief, when French finance minister, suggested that the agencies be banned from delivering ratings decisions on the eurozone countries being bailed out: Greece, Portugal and Ireland. "It's just an idea," Barnier added. He said he would ask the Poles on Monday, who are chairing the EU, to put a ban on the agenda of EU finance ministers. Jacek Rostowski, the British-born Polish finance minister and former Tory party member, will be chairing the meetings of EU finance ministers for the next six months. He looks an unlikely convert to the Barnier ban.
Fitch Downgrades Greece's Credit Rating To One Step Above Default
Greece suffered another sovereign downgrade on Wednesday, when the Fitch agency slashed its credit worthiness by three notches further into junk status and only one grade above default. The agency cut Greece's rating from B+ to CCC, bringing it in line with the other two major agencies, Moody's and Standard and Poor's, which had downgraded the country's bonds to a similar level last month.
Greece relies on loans from a euro110 billion ($155 billion) international bailout from other eurozone countries and the International Monetary Fund, and discussions are under way for a second bailout to keep the country's crisis from destabilizing other larger European economies.
However, no decisions have been made so far on how much more help Greece will get or in what way private holders of Greek bonds could contribute towards easing repayments. Credit ratings agencies have warned they could consider a voluntary rollover of Greek debt as a form of default. "Today's rating downgrade reflects the absence of a new, fully-funded and credible EU-IMF program for Greece, coupled with heightened uncertainty surrounding the role of private creditors in any future funding, as well as Greece's weakening macroeconomic outlook," Fitch said in a statement.
While the main aspects of further help were discussed at a meeting of EU finance ministers earlier in the week, "no further clarity on the volume and the terms of new money or the nature of private sector participation was forthcoming," it said. The agency also noted that Greece has been missing fiscal targets set out as conditions for receiving the first bailout, from which it began drawing funds in May last year.
"Fitch's 'CCC' rating encapsulates substantial credit risk and acknowledges that default is a real possibility," it said. "As previously stated by Fitch, private sector involvement would likely be viewed as a sign of sovereign credit impairment and could trigger a rating default event. The move came as the IMF said Greece's government must move quickly and decisively to bring its huge public debt under control.
To the outrage of labor unions across the country, the government has embarked on a punishing new round of austerity measures after missing its deficit-cutting targets so far in 2011. Spending cuts and tax hikes have already sparked frequent strikes and demonstrations, with protests often turning violent in central Athens.
Europe Readies for the Worst
by David Enrich, Sara Schaefer Muñoz and Tom Lauricella - Wall Street Journal
Some of Europe's biggest banks are taking steps to shore up their defenses should the debt crisis spiral out of control and one or more countries leave the euro zone, a sign of the financial sector's increasing worries over the continent's plight.
Some banks recently have been reining in some cross-border lending to companies in countries like Spain and Italy, bank officials say. Others are parking more money with the European Central Bank, according to ECB data. Banks also are increasing their use of credit-default swaps as protection against their holdings of sovereign debt from shaky countries.
As the crisis deepens, even European central banks are considering the possibility that one or more countries could leave the currency bloc, according to people familiar with the matter, a scenario that until a week ago seemed to many as implausible.
Overall, European banks appear to be growing increasingly wary of lending to each other, even on a short-term basis. Deposits parked at the European Central Bank's overnight deposit facility jumped Tuesday to €90.5 billion ($127 billion), up from €65.7 billion a day earlier. The last time the ECB's deposit facility was so flush was more than five months ago, on Feb. 7, when banks stashed €137 billion there.
While the amount of funds parked in the ECB facility ebbs and flows over the course of each month for technical reasons, it has historically been a good proxy for how fearful banks are about lending to each other—and about the financial crisis intensifying.
The moves reflect mounting concern that Europe's political leaders lack the will to adequately address the Continent's problems. The worries have shifted from concerns that Greece may default on its debts to a more dramatic scenario where Greece or another country departs the currency bloc.
Although the European debt crisis has been dragging on for roughly a year and a half, it appears to have entered a new, more perilous, stage this week. Expectations have faded that European officials will be able once again contain Greece's problems and avoid a destabilizing default that would inflict losses on banks holding Greek debt.
In the process, the spotlight has turned back to Italy and Spain's debt problems. Earlier in the year it had become conventional wisdom that despite economic and fiscal problems of their own, those countries had been walled off from Greece's woes. But the recent focus on Italy suggests that isn't the case. "Apart from the ECB, there are currently no big wallets in the EU that are capable of supporting Spain and Italy," said Willem Buiter, Citigroup Inc.'s chief economist.
One senior London banker said his bank is drawing in untapped credit lines to companies in Spain and Italy. An official with another major European bank said it is considering similar moves, although it is nervous that such actions could send a destabilizing signal that the bank is in trouble.
The departure of a country from the euro zone could expose banks with big operations in such countries to the risk of rapid currency devaluations and other turmoil. One banker said his bank was increasing its hedging to protect itself. An official at another bank said the situation in Italy is being monitored "moment by moment."
The defensive moves have the potential to put further pressure on those economies by reducing the already limited supply of credit. This occurred at the outset of the U.S. financial crisis in 2008, deepening the recession. One official said the situation in Italy is being monitored "moment by moment."
Officials at some banks said they sliced their exposures to at-risk countries more than a year ago and so new steps are unnecessary. Banks are also closely monitoring their funding positions, alert to the possibility that panicky depositors will start yanking funds from lenders connected to the euro-zone crisis, industry officials say.
There are signs that some depositors, such as the U.S. money-market funds that represent a key source of funds for many European banks, are growing increasingly jittery. Officials with two relatively healthy European banks said they recently have been attracting more short-term deposits, despite the fact that they are offering ultra-low interest rates. The officials said the uptick in deposits is indicative of a flight to safety.
On Tuesday, financial markets more broadly were tossed back and forth by the latest news, but the selloff in Italian and Spanish bonds took a breather. The yield on Italian two-year debt edged back to 3.9% Tuesday from 4% Monday, according to Tradeweb. But yields are up sharply from last week, when they closed Friday at 3.4%. Spanish bond yields also fell slightly Tuesday.
In the currency market, the euro fell to $1.3847 during European trading hours from $1.4030 late Monday, bouncing back to 1.4050 by Tuesday afternoon in New York, then falling again to $1.3976 in the wake of Moody's Investor Service downgrade of Ireland's ratings
In the U.S., a main gauge of stress in the credit market shows increasing worries about counterparty risk as the euro-zone debt troubles increasingly threaten to spill over into larger economies. The two-year U.S. swap spread, which measures the gap between swap rates and Treasury yields and is considered a prime indicator of risk aversion, widened to 0.30 percentage point, 0.015 percentage point wider from late Monday.
Swap spreads often move in tandem with credit spreads and are a sign that traders think their partners in an interest-rate swap trade will fail to hold up their end of the trade. Part of the reason for the increased fears surrounding the continent's banks is that European regulators on Friday plan to announce results of their months-long "stress test" of 91 top lenders. Senior bank executives and regulators in several countries are worried the increased disclosures banks must make as part of the process could fuel market fears by casting their financial positions in a poor light, say people familiar with the matter.
Adding to the jitters, Moody's Investors Service on Tuesday cut Ireland's credit rating to high-yield, or "junk," status. Moody's said the country, which last year received a €67.5 billion international bailout, "is likely to need further rounds of official financing before it can return to the private market."
Focus turned also to Italian banks. Like the situation in Greece, Italian banks and financial institutions have been big buyers of Italy's sovereign debt. That, in part, has helped Italian bond yields remain lower than comparable nations, such as Spain, says Nikolaos Panigirtzoglou, European head of Global Asset Allocation for J.P. Morgan Securities. "They made a decision—that it's important to support a domestic-bond market. Perhaps they thought that their fortunes were so linked that they had a shared interest," Mr. Panigirtzoglou said. "Now that is becoming a bit of a weakness for Italy."
If Italian banks feel they already own too much government debt, they may begin to stop buying Italian bonds, Mr. Panigirtzoglou said. Already, there is slackening interest from Italian banks in buying Italian debt, said bond traders at large global banks in London. That could create a vicious cycle in which bond prices fall—and yields, which move in the opposite direction, climb—in turn dissuading more banks from buying and driving yields still higher. Such a spike in yields would be a tough burden for Italy, as it would make the costs of servicing its debts more expensive and exert a significant drag on the economy.
Question of 'Who's next?' in European crisis grows louder
by Gail MarksJarvis - Chicago Tribune
Downgraded debt, falling markets raise risk of fallout reaching U.S.
Typically this is the time of year when fortunate Americans spend tranquil summer vacations relaxing in carefree outdoor European cafes.
But this summer, images of Europe couldn't be more devoid of that serene picture. Rather, some investors across the U.S. are awakening at 3 or 4 in the morning to flick on computers and TVs and check European markets for early warning signs of damage to American 401(k)s and IRAs.
Monday, the Dow Jones industrial average dropped 151 points as European markets fell amid worries that Italy would be Europe's next emergency-debt case. Tuesday, the Dow was a little calmer as Italy's markets ended a six-day slide. The Dow closed down 58 points. But a downgrade of Ireland's debt to junk status emphasized once again the erosion of financial conditions on Europe's periphery and the tremendous price the European Union would bear if it had to bail out Greece, Portugal, Ireland, and maybe even Spain and Italy.
"It's becoming very scary," said Bonnie Baha, developed markets bond portfolio manager for DoubleLine Capital. "The world has become a much smaller place, and the end game is hard to see."
At issue is whether these five eurozone nations, collectively known as PIIGS, can afford to pay their debts. And if they can't, the concern is that banks could be hard-hit. Banks could be affected in multiple ways — perhaps by having extended loans to countries, companies or other banks that could not repay the money. There could be a cascading effect, with one bank not getting repaid and then failing to pay another.
For example, French banks have a significant exposure to Greece, and if Greece defaults on its debt, a French bank then might have trouble repaying money it owes a U.S. bank.
If many loans go bad, there could be a credit crunch in Europe in which banks would be forced to hold onto capital rather than make loans. This conjures up memories of the days following Lehman Brothers' failure, when lending came to a halt.
Without being able to borrow money, businesses and consumers would have to curtail spending, and economies could dip into recessions, said George Feiger, chief executive of Contango Capital Advisors in San Francisco. He is so concerned about large European banks he no longer has clients put money into U.S. money market funds that invest in short-term commercial paper from banks.
If European banking problems cause a credit crunch and slow the economies, companies in the U.S. and around the world could have trouble selling products in European markets.
At this point, the risk is conjecture because the exposure in the banking system is not clear. "The sovereign debt crisis will remain a key focus of the markets this week as European finance ministers meet to discuss how to resolve the crisis, and bank stress tests out later in the week will highlight how exposed the European banking system would be to a default," said Moody's economist Melanie Bowler.
Analysts have been trying to estimate the risks in the banking system. For example, Anil Lalchand of DoubleLine Capital says that if Greece defaults, the most exposed banking systems are those of France ($65 billion) and Germany (about $40 billion). European banks in general have roughly $162.4 billion of exposure, he said.
Greece is the most troubled European country to date, and according to the Bank of International Settlements, the U.S. has $41.5 billion in claims to Greece. U.S. banks don't have to disclose their foreign-country exposure unless it is greater than 0.75 percent of total assets. Both Citigroup and Morgan Stanley have reported relatively small exposure to Italy, and Goldman Sachs has an $8.3 billion commitment with Ireland, said Lalchand.
But the risk doesn't stop there, according to Lalchand. "The top five U.S. banks have exposures to Germany and France, the largest bank lenders to Greece. The interconnectedness of the U.S. and European banking systems can hardly be lost on markets and policymakers post-bailout of American International Group (AIG)."
"The fear," said Baha, "is that this is like a man drowning in quicksand. All that try to help could be dragged in too." Companies also can be tarnished by sovereign debt problems. "Even if Fiat is a fine company with decent management, their corporate rating will be constrained if sovereign Italian debt is downgraded," said Baha.
Anxious investors Tuesday moved money into U.S. Treasury bonds, and the yield on 10-year Treasurys fell to 2.87 percent.
Yet, Moody's economist John Lonski was surprised that the euro stayed above $1.40. That may be because investors are also worried about how the U.S. will cope with its debt, he said. But he also wonders if investors are looking at "ongoing financial market turbulence" as a lever that will finally prompt policymakers in the U.S. and abroad to resolve debt issues.
"Kicking the can down the road may no longer suffice," he said.
Draghi Says EU Debt Crisis Is in New Phase
by Lorenzo Totaro and Jeffrey Donovan - Bloomberg
Europe’s debt crisis has entered a new phase and policy makers must come up with a "clear" response to stop the contagion that threatens the region’s single currency, said the European Central Bank’s incoming President Mario Draghi.
"It’s now necessary for those trying to manage the sovereign crisis to give certainty, to define with clarity the political objectives, the scope of the instruments and the amount of resources available," Draghi said today in a speech in Rome. "It’s a necessary step to ensure the stability of the euro area and its currency."
European governments can no longer count on their financing costs remaining similar to those of Germany, the region’s strongest economy, simply because of their participation in the
single currency, he said. "The solvency of the sovereign states is no longer something acquired he said, but something earned with high and sustainable growth, which is only possible if budgets are in order," Draghi, who also heads the Bank of Italy said. "Today’s cost of credit reflects that new reality."
Draghi’s comments at the annual meeting of Italy’s banking association came after Italian bonds and stocks plunged in recent days on concern the country would struggle to reduce the euro-region’s second-biggest debt. The yield on Italy’s 10-year bond reached the highest since 1997 and financing costs at a sale of treasury bills surged on investor concern that Italy would be the next victim of the region’s debt crisis.
Italian bonds gained today on pledges by the government for swift passage of a 40 billion-euro ($64 billion) deficit- reduction plan that seeks to balance the budget in 2014. The premium investors demand to hold Italy’s 10-year bond over German bunds fell 17 basis points to 269.3, down from a euro-era record of 348 reached during trading yesterday.
Italian Finance Minister Giulio Tremonti, speaking at the same conference, said the plan would be passed by both houses of parliament by July 15. Opposition parties have agreed to ease passage of the measure in the legislature. "Italian politicians decided to respond firmly to market concerns over the credibility and implementation of the 40 billion-euro fiscal package," Fabio Fois, European economist at Barclays Capital in London said in a note to investors. "These are clearly positive developments. The fiscal plan was originally supposed to be voted on at the beginning of August."
The deficit plan is "an important step in strengthening the public accounts" that will help reduce the debt, Draghi said. He also called on the government to explain details of additional measures for 2014 that will be needed to achieve the balanced budget. Tremonti did say the government was considering a plan to sell off more state-owned assets "once the crisis passes."
Austerity measures won’t be enough for Italy and other euro-region countries to reduce debt if not accompanied by policies to boost economic growth, Draghi said. The Bank of Italy expects Italian growth to continue to lag behind the euro area average for the next two years, he said. Second-quarter growth did expand at a similar pace as that of the euro region, Draghi said, reversing the trend in the first three month when Italy grew 0.1 percent, a fraction of the 0.8 percent rate for the euro area.
In contrast to many European economies, Italy has the advantage of a solid banking system and a declining jobless rate, Draghi said. Italian lenders will pass stress tests this week with a "significant" margin of capital above the core Tier 1 minimum, he said. He estimated the lenders still need to boost capital by 20 billion euros to meet Basel 3 standards for 2019, he said.
Italy’s borrowing costs soar
by Guy Dinmore and Joshua Chaffin - Financial Times
Italy’s borrowing costs soared to their highest level in over a decade amid highly volatile trading as market contagion from Greece forced Silvio Berlusconi to appeal for national unity and "sacrifices" to cut the nation’s debt mountain. "We are in the front line of this battle," Mr Berlusconi said, describing a crisis that threatened all of Europe and the future of its common currency.
The Italian prime minister’s appeal – the most sombre in his three years in charge of his centre-right government – was intended to rebut widespread criticism in the Italian media and the markets that his coalition was rudderless and divided by disputes between him and Giulio Tremonti, finance minister. "We have to eliminate any doubts over the efficacy and credibility of our budget," Mr Berlusconi said, insisting that the €40bn package would eliminate Italy’s budget deficit by 2014.
Opposition party leaders in Rome pledged their co-operation in parliament to pass the government’s three-year austerity programme by Friday in time for a possible emergency summit of EU leaders in Brussels that day. "This would be a record in Italian history," Enrico Letta of the opposition Democrats told the Financial Times. "Never before has a budget been passed in five days."
Italian banking sector shares plummeted further at the opening of trading on Tuesday and its benchmark 10-year bond yields hit a euro-era high of 6.09 per cent before markets recovered substantially on news that Mr Tremonti was returning early to Rome from Brussels for emergency talks with the opposition.
Under media fire for spending too much time on dealing with his media empire’s own financial woes, Mr Berlusconi also rushed back to Rome after cancelling a trip to watch his AC Milan football club in training. A relatively successful sale by the Italian Treasury of €6.75bn of 12-month bills – albeit at the highest yield for three years – calmed markets. Some traders said they believed China had stepped in.
France is also being affected by the market volatility as the premium it pays for debt over Germany hit a new euro-era high on Tuesday. French 10-year yields were 0.7 percentage points higher than equivalent German ones. And Irish debt was downgraded to junk by Moody’s, which loweerd its rating on the embattled country one notch to Ba1, saying it was likely to need a second bail-out. Mark Schofield, head of interest rate strategy at Citi, said: "France is now trading like Spain and Italy did [before this week]."
In Brussels, finance ministers agreed late Monday night to enhance the flexibility of eurozone’s €440bn temporary bail-out fund – a move that was widely interpreted as a signal that the fund would be allowed to begin buying distressed government bonds in secondary markets.
That approach – long rejected by Germany – would allow Greece to erase part of its sizable debt burden. In hopes of bringing further relief, finance ministers also pledged to lower interest rates and extend debt maturities.
Hopes were raised that a new and more comprehensive bailout package for Greece was at hand after Herman Van Rompuy, European council president, sounded out member states about holding an emergency summit on Friday. But in spite of the progress, diplomats said that it was not clear if a detailed package could be readied in time.
Berlusconi's Last Stand
by Michael Braun - Spiegel
Italy is used to crises -- the government is rudderless, the economy is stagnant and Prime Minister Silvio Berlusconi is mired in scandals. Now the country may become embroiled in the euro crisis, and its fate lies in the hands of its finance minister. Berlusconi, for his part, faces the ruins of his political career.
After a black Friday and a black Monday the nation initially seemed to be facing a black Tuesday. The market indices in Milan on Tuesday morning looked disastrous. The stock market fell by up to 5 percent in the first few hours of trading, after having sustained losses of 3.5 percent on Friday and 4 percent on Monday. The yield spread between Italian and German debt kept widening as well. Just a few weeks ago, the rate on Italian 10-year bonds was just two percentage points higher than comparable German paper. On Monday, the difference grew to three percent and on Tuesday it reached 3.5 percent.
This turmoil coincided with the auction on Tuesday of almost €7 billion worth of 12-month bills. If the sale had failed, or if it had even been undersubscribed, the markets may have panicked. But the whole issue found buyers, albeit at significantly higher interest rates. The gross yield on the bills rose to 3.67 percent from 2.15 percent at the previous auction in June.
The Milan bourse breathed a sigh of relief and was in positive territory for several hours -- but it is likely to remain a rollercoaster in the coming weeks. The country, its economy, banks, government and citizens have suddenly been subjected to a stress test that came completely out of the blue.
'Aren't That Bad'
Economists interviewed on television on Tuesday kept on repeating the mantra that "Italy isn't Greece or Portugal," and "Italy's economic fundamentals aren't that bad."
And it's true: no real estate bubble has collapsed in the country, banks aren't battling enormous sums of toxic investments and new state debt is well below that of France, for example. Italy's unemployment rate is at 9 percent, miles away from Spain's 20 percent. The country -- the third-largest economy in the EU -- has a solid industry structure, mainly thanks to tens of thousands of small and mid-size businesses, which still earn billions each year through exports.
Nevertheless, Italian commentators, whether in left-wing journals or the conservative and financial press, have shown surprisingly little inclination toward passing the buck onto "the speculators." The staunchly left-wing daily Il Manifesto is dryly balanced. "Italy is paying for a double weakness, the political and the structural," it wrote. The conservative Corriere della Sera stands strong: "It doesn't help to get excited about international speculators. If we conduct ourselves seriously then we have nothing to fear. Unfortunately we have not been serious up until now. For that, the markets are paying."
The accusation about insufficient seriousness is, of course, directed mainly at Prime Minister Silvio Berlusconi, who is preoccupied with his scandals and legal battles. Just last Saturday, one of the companies he owns was sentenced to pay damages of some €560 million to a competing media company.
When he is forced to address political problems facing Italy, he is often not more destructive than constructive. When it came to a massive, €47 billion austerity package, Berlusconi attacked his finance minister, Guilio Tremonti, saying he was not a "team player." He then referred to "Tremonti's plan" as though he had had nothing to do with it.
Behind this lies Berlusconi's fear that further cuts would be unpopular. At the same time he knows full well that Tremonti is Italy's only guarantee for solidity, which says everything about the state of the government. "This worries me greatly, because the credibility of a country can't hang on a single man," economist Paolo Guerrieri said.
It is probably no coincidence that the speculative attack began on Friday in Italy. This week the Italian parliament begins debating the austerity package, which the ruling parties are expected to dilute considerably. The exercise will now probably be even easier, because Tremonti just took a hit -- he and one of his closest allies, parliamentarian Marco Milanese are under investigation for corruption. Milanese allegedly provided Tremonti with an apartment worth €8,000 per month for free.
A political leadership that lacks direction, a country that has fundamental growth problems: Italy has been stagnating for years. Since the global economic and financial crisis, the country has only been able to manage growth of a single percentage point annually. Just how it plans to pay off its debts, which are the equivalent of 120 percent of its gross domestic product, remains a mystery.
Opposition Signals Quick Passage of Austerity Package
On Tuesday, though, the country's politicians managed to send a signal of determination -- led by the opposition. Italian President Giorgio Napolitano, himself from the leftist camp, had appealed to the opposition for "national resolve." And he quickly got what he wanted. All three opposition parties in parliament pledged not to stand in the way of the passage of a package of austerity measures within the next week. They won't vote in favor, but they vowed not to slow down the bill with a slew of amendment requests. Furthermore, even the final passage of a budget this Sunday is now seen as a possibility.
It is partly for this reason that the situation on the Milan stock exchange relaxed on Tuesday. Furthermore, the risk premium on Italian bonds dropped again and is now back to just three percentage points higher than the German benchmark. But the opposition also made it clear that they see this as Berlusconi's last battle. Massimo D'Alema, head of the leftist Democratic Party, said that once the austerity package is passed, Berlusconi should "go immediately" and make room for a new government aimed at improving the country's financial health.
And Berlusconi himself? Little had been heard from him for the last four days -- until Tuesday afternoon. His coalition, he said, is "unified and determined." He said he welcomed the conciliatory gestures from the opposition -- and said nothing at all about a possible resignation. But in the end, his future lies more in the hands of the financial markets than it does with the Italian parliament. Any additional signs of investor distrust could signal the end of the road for Berlusconi.
Eurozone policymakers must grasp the nettle
by John Plender - FT
The limits of eurozone policymakers’ efforts to address the sovereign debt crisis were cruelly exposed by Monday’s rise in Italian government bond yields. This contagion all the way from lowly Greece to one of Europe’s big four economies opens up a new phase in the drama. For while the markets cheered up a little on Tuesday in response to a successful auction of short term Italian paper, I doubt that the contagion has gone away.
There is no way round the fact that the markets believe there is a solvency gap in southern Europe that can only be met by debt relief. They fear that fiscal retrenchment is strangling chronically weak economies that are seriously uncompetitive and unable to devalue their way out of the problem. Policy is thus increasing the risk of sovereign default while promising years of deflation for the embattled countries of the region.
Investors are also conscious of a vicious circle at the heart of the eurozone. Undercapitalised banks are supporting over-indebted governments by holding their IOUs; over-indebted governments are supporting troubled banks; and there is insufficient equity in the European banking system to absorb the losses implicit in the solvency gap. The outcome is that the European Central Bank ends up providing liquidity on an open-ended basis to the peripheral countries to keep their banking systems afloat at the cost of an ever weaker balance sheet. The one surprise in all this is that more of the retail deposit base of southern Europe has not disappeared in capital flight.
An optimist would say that Italy has long been a rich economy shackled to an unworkable state, so the markets’ worries about the political dogfight over a tougher fiscal strategy are overdone. A further ground for hope is that eurozone ministers’ meeting on Monday produced a proposal to enhance the flexibility and scope of the European Financial Stability Facility, to lengthen the maturities of loans and lower the interest rates. That suggests the beginnings of a shift in attitude towards debt relief. It could also pave the way for the EFSF to buy government bonds in the secondary market, which would help address the contagious rise in government bond yields.
But shock and awe it was not. And the more striking thing about eurozone crisis management remains the extent to which it represents displacement activity. Last week’s decision by Moody’s to downgrade Portugal to junk status prompted angry protests from finance ministers and central bankers. But how could a rating agency in good conscience accord investment grade status to a country that has had to go to the European Union and the International Monetary Fund for a bail-out? The more relevant question is why the downgrade did not happen earlier.
These criticisms are tinged with xenophobic hostility to American ownership of the agencies, notwithstanding the fact that Fitch, the number three rater, is French owned. Hence a suggestion that the EU should encourage the development of European rating agencies, presumably to deliver more politically correct ratings which no one would trust. This is on a par with European politicians’ urge to make the hedge funds the scapegoat for a financial crisis for which they had no responsibility at all. As for the finance ministers’ suggestion that Europe should consider suspending credit ratings for countries in official bail-out programmes, that would reliably provoke an offshore shadow rating system.
Equally worrying has been the calls by German regulators and Spanish banks for weaker bank stress tests. What merit the current approach to the crisis has, boils down to buying time so that, among other things, weak banks can recapitalise themselves. Fudging stress tests is not the way to inspire confidence among investors who will have to put up the fresh capital. Since the credibility of the new European Banking Authority hinges on the robustness of the tests, which are due this Friday, I hope and believe that it will not have given any quarter to its critics.
Underlying all this are a number of irreconcilables. One is that the politicians do not trust the markets, while the markets think the politicians have failed to grasp the nature of the crisis. Another is that the taxpayers of northern Europe do not want to bail out what they perceive to be profligate and lazy southern Europeans. Yet their elected politicians cannot contemplate the alternative of sovereign default because that would put the whole European banking system at risk. The upshot is a form of crisis management that the financial community dubs "extend and pretend". There will be plenty more extending and pretending before eurozone policymakers reach the point of grasping nettles.
British age of austerity to continue for decades, warns OBR
by Heather Stewart - Guardian
Office for Budget Responsibility report suggests UK will continue to pay the price for an ageing population and declining tax levels
Britain must brace itself for decades of austerity even after George Osborne's spending squeeze, to pay the price for an ageing population, the independent Office for Budget Responsibility (OBR) warned on Wednesday. The OBR, set up by the chancellor to produce independent projections of the public finances, says the rising cost of healthcare and pensions, and declining tax revenues from the North Sea, will mean future governments have to take action to prevent debt levels rising inexorably.
Without fresh tax rises or spending cuts, the OBR says, the government's debt will hit a trough of 60% in the mid 2020s, compared with less than 70% now, before rising rapidly to hit 107% of GDP by 2060-61. Although the deterioration in the public finances is more than a decade away, the OBR urges politicians to make long-term decisions now, to prevent the economy drifting into a debt crisis as the population ages.
"Policymakers and would-be policymakers should certainly think carefully about the long-term consequences of any policies they introduce in the short term. And they should give thought too to the difficult choices that will confront this country once the challenge of the current consolidation has passed," the study says.
The OBR's report coincides with the publication of new "whole of government accounts" from the Treasury, which include new – and much larger – estimates of the state's long-term commitments, based on treating the government as though it were a business, with assets and liabilities. The "net present value" of paying public sector pension promises – a way of calculating the cost if they all had to be paid today – had already hit almost 79% of GDP, or £1.1trn, by March 2010, according to the Treasury's calculations.
The price of Labour's Private Finance Initiative – Gordon Brown's favoured method for building new schools, hospitals and infrastructure without the Treasury paying the whole bill up front – is put at £40bn.
Meanwhile, the state's other "contingent liabilities", which the Treasury hopes it will never have to pay, such as guarantees to the crisis-hit banking sector, amount to more than £200bn.
Set against the government's assets, which the Treasury calculates to be worth £759bn, overall public sector liabilities now stand at £1.2trn, or 84.5% of GDP.
Despite these eye-watering estimates, however, the OBR says the main reason taxpayers must get used to decades of austerity is the growing burden of an ageing population, with its inevitable knock-on effects in terms of pensions and healthcare.
"Balance sheet measures look only at the impact of past government activity," it says. "They do not include the present value of future spending that we know future governments will wish to undertake, for example maintaining health, education and pension provision. And, just as importantly, they exclude the public sector's most valuable financial asset: its ability to levy future taxes."
They estimate that health spending will have to rise from 7.4% of national output in 2015-16 to almost 10% by 2060, while state pension costs will hit almost 8% of GDP over the same period, and social care costs increase to 2% of GDP.
Despite the hefty estimate of the net present value of public sector pensions, the annual cost of paying retired public sector staff will actually decline over time, the OBR says, because of the chancellor's decision to uprate them in line with the lower consumer price index measure of inflation, instead of the Retail Price Index.
The Next Domino? Italy Suffers from Euro-Zone Contagion Fears
by Carsten Volkery - Spiegel
Italy has slid into the speculators' crosshairs amid concerns that the euro-zone crisis could hit the country next. In many respects, Italy is much better off than its neighbors on the periphery. But unlike Greece, it is definitely too big to fail.
The symptoms are all too familiar. The risk premium on Italian government bonds reached a new high on Monday, stocks fell and the Milan stock exchange restricted short-selling as a precaution. Italy has suddenly become the focus of international investors' attention. New doubts about the stability of the Rome government and a deep skepticism about the country's finances have combined to form a dangerous mixture. The national debt is at 120 percent of gross domestic product (GDP), the second highest in the euro zone after Greece.
But how bad is Italy's situation really? The investors' attacks have not come as a huge surprise. Even when the single currency was introduced, the country, with its huge mountain of debt, was already viewed as a potential problem. It was inevitable that the markets would sooner or later test the vulnerability of Italy, as one of the euro zone's weak points.
The rating agencies fired initial warning shots in recent months. In May, Standard & Poor's changed the outlook for Italy to negative, on the grounds that the government was not sticking closely enough to its austerity goals. In June, Moody's followed, announcing it wanted to review Italy's AA2 rating. Justifying their skepticism, the analysts referred to the country's weak economic growth, low productivity and rigid labor market.
Different to the Others
Indeed, Italy resembles the other ailing countries on Europe's periphery in all these respects. But there are also huge differences, which make the present state of alarm on the markets seem excessive:
- Large, diversified economy: Italy is one of the seven leading industrial nations (G-7) and is home to several global companies. It may have plenty of olive trees, but the country is also an industrial and creative powerhouse. Internationally successful car makers, industrial designers and fashion designers contribute to Italy's export successes.
- High savings rate: The country is sometimes referred to as the Japan of Europe because of its savings rate, which is high by European standards. In addition, many Italians invest their money in their country's own sovereign bonds. Some 55 percent of the national debt is in Italian hands. The country thus has less reason to fear a capital flight by foreign investors than, say, Ireland.
- Liquid bond market: Although Italy's debt burden is almost legendary, the country has proven in the past that it can cope well with it. The Italian bond market is the third largest in the world, after the US and Japan. A large bond market has significant advantages: There are always investors willing to buy Italian bonds, because they know that they can always get rid of them again easily. Italy has therefore never had problems refinancing its debt.
Even the biggest skeptics do not expect that Italy will get into financial difficulties any time soon. Compared to Greece, more of Italy's national debt of €1.9 trillion is financed through long-term debt. Securities worth €80 billion will come due by the end of 2011. The government will need to issue new debt to replace them. On top of that, the country will also issue around €90 billion in new short-term debt.
So far, Italy has not had problems issuing new debt, but worries are growing about the rising cost of financing existing debt: The interest rate on 10-year bonds rose to 5.5 percent on Monday. The experience of other euro-zone members shows that the critical level is around 7 percent. If yields rise above that level, then markets develop their own momentum which is hard to stop.
The main problem, however, is that investors are suddenly asking how the government in Rome plans to ever pay off its debt. Economic growth is weak: In the first quarter of this year it was just 0.1 percent, well below the euro-zone average of 0.8 percent. With declining productivity and an ageing population, the prospects of a recovery are not promising.
Italian Finance Minister Giulio Tremonti has recognized the danger. He is pushing for strict austerity measures in order to balance the budget by 2014 and begin reducing the level of debt. But Tremonti has been weakened domestically, after he had to distance himself last week from a corrupt associate and Prime Minister Silvio Berlusconi publicly announced changes to the austerity package in an interview.
Investors now fear that Berlusconi may be planning to get rid of the finance minister. Tremonti himself was recently quoted as saying that if he should fall, Italy and the euro will follow. He was perhaps overestimating his own importance. But the nervousness in the markets shows what effect his departure could have.
Should Italy fall into the vicious circle of downgrades and rising bond yields, the consequences would be disastrous for the euro zone. A new banking crisis would be likely. German banks alone had €116 billion in exposure to Italian debt at the end of March. By comparison, they are only holding €17 billion in Greek debt.
Spanish Budget Gap Adds to Worries
by Jonathan House - Wall Street Journal
The new leader of Spain's Castilla La Mancha region said on Monday that it has a budget deficit more than twice as large as had previously been thought, raising new concerns over the true state of regional finances and helping to send Spain's risk premium to records.
Castilla La Mancha President María Dolores de Cospedal said her government will on Tuesday present the first results of the audit she announced after being elected on May 22. "With the debts we've found unpaid as of June 30, the deficit is much higher than we were told," she said in an interview with Onda Cero radio station. "[Tuesday] we will see the exact figure…but it will likely be much higher than 4%," added Ms. Cospedal, who is also the No. 2 national official of the opposition Popular Party.
The outgoing regional government of Socialist José Maria Barreda had said Castilla La Mancha had a budget deficit equal to 1.78% of local gross domestic product in April, well in excess of the 1.3%-of-GDP limit for 2011 set by the central government in Madrid for each of Spain's 17 regions.
Roberto Ruiz, UBS strategist in Madrid, said the news on Castilla La Mancha "fanned the flames" of worries over Spanish finances. Largely the result of increased investor unease over Europe's inability to solve Greece's financial problems, Spanish and Italian risk premiums—as measured by the spread of their 10-year government bond yields over the German benchmark—soared to records on Monday. The yield premium investors demanded to hold Spanish paper surpassed three percentage points for the first time since the creation of the euro in 1999.
The news also raises the pressure on the national government of Prime Minister José Luis Rodríguez Zapatero to rein in regional spending at a time when the Socialist leader seems increasingly sidelined.
On Monday, he announced a series of appointments to fill the positions left vacant by Alfredo Pérez Rubalcaba, who was deputy prime minister, government spokesman and interior minister. On Saturday, Mr. Rubalcaba was officially named the Socialists' candidate for prime minister in national elections that must be called by March, and he is increasingly seen as the party's dominant figure.
Spanish regions control more than a third of spending and are essential to the country's plans to slash an overall public-sector deficit of just over 9% of GDP in 2010 to 3% in 2013. But they have made little progress in budget overhauls mandated by the central government in Madrid. In addition, since a change in government in the wealthy but highly indebted region of Catalonia last year uncovered a much larger deficit than was previously acknowledged, the accuracy of regional accounts has been under suspicion.
The May 22 elections unseated Mr. Zapatero's Socialists—undermined by a deep economic crisis— from six of the seven regions they governed. Ms. Cospedal and other incoming Popular Party leaders had promised to audit the accounts of the local governments. Castilla La Mancha, which reported a 2010 budget deficit of 6.5% of GDP, the highest of all Spanish regions, was already known to have deep financial problems. And it is a relatively small region that accounts for just 3.4% of national GDP. Still, its revelation of a worse-than-expected deficit "shows a dangerous trend," Mr. Ruiz said.
Ms. Cospedal said she had sent a letter to Spanish Finance Minister Elena Salgado, asking her for an urgent meeting to discuss the "worrying state of Castilla La Mancha's finances." The central government is due to call a meeting with all regions to discuss deficit-cutting plans by the end of July.
Spanish Banks More Vulnerable Than Italy's
by Simon Nixon - Wall Street Journal
If any doubt remained over how closely Europe's sovereign and banking crises are intertwined, the latest contagion has laid the linkages bare. Shares in Italian and Spanish banks have slumped as their governments' debt costs soar; many now trade below their post-Lehman lows. But while Italy's banks are a binary bet on a euro-zone solution to its debt crisis, Spain's banking woes are more fundamental.
Italy's bank woes are directly linked to the sovereign-debt crisis. Until Italy found itself at the center of the market storm last week, Italian banks looked relatively strong. Between them, they have raised more than €8 billion ($11.22 billion) of capital this year and most banks now have an average core Tier 1 ratio above 8%. Italian banks also have relatively low reliance on wholesale funding. Until recently, the market's biggest concern was the sector's low profitability, reflecting high costs, low credit growth and low interest rates.
But the loss of market confidence in the sovereign has raised fresh worries. Italian banks own government bonds equivalent to 13% of total bank assets—among the highest exposure of any major economy banking system, according to the International Monetary Fund. In contrast, Spanish banks' exposure to their own government is just 6.8% of bank assets; for U.S. banks, it is 5% and the U.K. just 1.5%. The only banking system more exposed to its own government is Japan's at 24% of bank assets.
The good news for Italian banks is that if the euro zone does succeed in addressing its sovereign-debt crisis, share prices might quickly recover. Although the turmoil in Italy partly reflects fiscal and political concerns, the biggest problem has been Germany's insistence on private-sector involvement in any fresh Greek debt deal. This has spooked investors who fear they will be forced to take losses as a first rather than a last resort. A solution that avoided that would reassure bondholders.
But Spain's banks won't escape the spotlight so easily. The market believes the banking sector is woefully undercapitalized and the latest volatility will further hamper the initial public offerings of savings banks Bankia and Banca Civica—crucial for restoring confidence. Bankia looks particularly vulnerable as its IPO is constrained by the need to raise €4 billion without diluting its parent below 50%.
Worse, heavy issuance of covered bonds has left Spanish banks with a shortage of collateral for future funding, according to UBS. To ease the pressure on Spain, a far-reaching euro-zone bailout package is needed that will pave the way for greater recognition of losses and comprehensive bank recapitalization. That could take months to arrange. Until then, Spanish banks will continue to suffer.
Spanish protesters fight off repossessions
by Sarah Rainsford - BBC News
The crowd started gathering just after eight in the morning. Just a handful at first, then dozens - responding to a call for help sent out via Twitter and Facebook. By nine o'clock about 200 people were crammed into the street: a "flashmob" of placard-waving protesters, chanting and singing in defiance.
"We're here to stop the eviction of this family," Eloi Morte from the "Mortgage Victims" campaign group explained, shouting above the noise. Behind him, demonstrators blocked the entrance to a building with their bodies and huge banners. The family inside has been served notice to leave after defaulting on their mortgage. A bank representative and locksmith are due at any moment to take possession of the property.
"There is a crisis in Spain. People have no jobs, they can't pay!" Mr Morte insists. "So all over the country we are standing up against this kind of eviction. We won't let it happen," he says, as a chant of "They will not pass!" rises from the crowd.
During Spain's property boom that peaked in 2007, low interest rates encouraged a surge in credit-taking. But the sector's implosion has since destroyed more than two million jobs; unemployment is more than twice the EU average, at 21.3%. And now there is a new record: home repossessions are at an all-time high, with 180 families evicted every day, according to campaigners.
Maria Jose del Coto began to fall behind on her mortgage payments in 2008. The interest rate was climbing, and both she and her adult daughter were unemployed. Now the bank has repossessed the house and served them notice to leave. The protest outside is a last, desperate attempt at resistance. "Of course I'm worried, but I'm determined to fight this," Mrs del Coto says, inside her home of 30 years. "Not just for me, but for the many other people in even worse straits," she adds.
Like many, she feels duped into a mortgage arrangement she could never afford. "I understand the bank wants its money back," her daughter adds. "But if things are tough for the banks at the moment, they have to understand that families are in crisis too. They need to come up with some solutions until things improve, not kick us out."
In the street outside, the protesters are angry that banks - propped up with public funds - are now turning families in difficulty onto the street. There is bemusement it is happening at all, when almost 700,000 unsold properties stand empty. The campaigners' main demand is for a legal change to allow people to clear their entire debt by handing their home to the bank if they cannot meet the mortgage. Currently, if a bank sells a repossessed home for less than the value of outstanding debt, the borrower is liable for the difference.
The campaigners want the change applied retrospectively. "Forgiving debt is always a possibility, but making it mandatory retroactively is crazy," argues economist Javier Diaz Jimenez from Madrid's IESE Business School. He believes the best way to help those in difficulty is for the government to provide income support, not "meddle" with contracts.
"This is the heart and the blood of a market economy, you just don't do that. You will kill loans for ever if you do that. It is an outrageous idea," he says, pointing out that most businesses here are small- and medium-sized enterprises heavily reliant on access to bank credit. The Spanish Banking Association estimates that such a move would push the number of defaults from 2.4% of all mortgages to 8% in a year, putting an extra 4bn euros (£3.5bn; $5.6bn) on already strained bank balance sheets.
'Yes, we can!'
But the protesters gathered outside Maria Jose's house are determined. Their movement sprung from the mass demonstrations in May that began in Madrid's Sol square - against corruption, mass unemployment and a political class they felt had stopped listening to the people.
Now the "indignants" have found a new focus for their protest. "I remember the first night I was in Sol I was crying," recalls Helia Relano. "It was so incredible to realise you weren't alone; that lots of people were there to fight for what's right. This protest [now] is a clear continuation of that."
The government has already proposed changes to the law - apparently in response - including protecting a higher percentage of a debtor's income against seizure by the banks. But the protesters demand more. Six hours after they first gathered in support of Maria Jose, Eloi Morte finally raises his megaphone: the bank has suspended her eviction until further notice, he tells them, to a joyful chorus of chants: "Yes, we can!" "It's the 48th success we've had so far in Spain," Mr Morte says, and vows that the campaign will continue.
For Maria Jose, he admits, it is only a temporary respite - but he says the protest has won her some breathing space. Now lawyers for the campaign group can pressure the bank to be lenient. "Obviously the bank won't accept the demands," Mr Morte shrugs. "But when we have another date for the eviction, we will be here again and again until we get a response."
China’s $1 Trillion Debt Seen Toxic as Cities Value Land at Winnetka Level
by Henry Sanderson, Michael Forsythe - Bloomberg
Workers toil by night lights with hoes, carving out the signs for Olympic rings in front of an unfinished 30,000-seat stadium, bulb-shaped gymnasium and swimming complex in a little-known Chinese city.
Loudi, home to 4 million people in Chairman Mao Zedong’s home province of Hunan, is paying for the project with 1.2 billion yuan ($185 million) in bonds, guaranteed by land valued at $1.5 million an acre. That’s about the same as prices in Winnetka, a Chicago suburb that is one of the richest U.S. towns, where the average household earns more than $250,000 a year.
In Loudi, people take home $2,323 annually and there are no Olympics here on any calendar. "The debt isn’t a problem as Loudi is not a developed place," Yang Haibo, an official at the city’s financing vehicle, says as he sits with colleagues in a smoke-filled meeting room under a No Smoking sign. "It’s an emerging city."
A 3,300-mile (5,310-kilometer) tour of three cities in China, coupled with reviews of dozens of Chinese-language bond prospectuses that offer an unusually transparent view into local government debt, shows just how widespread such borrowing has become. In China, as in the U.S. before the collapse of the subprime mortgage market in 2007, local debt is backed by collateral that is overvalued, may be hard to sell and, in some cases, doesn’t exist.
Officials in Loudi, whose colonnaded government building is locally nicknamed the White House, value their 18 tracts of land at almost four times what a similar plot sold for in May. In the northeast city of Cangzhou, the man in charge of the assets financing a port expansion can’t locate the land his company posted as collateral for a 1 billion-yuan bond sale. And a spending spree in Yichun, a district on the Russian border covered by ice much of the year, is backed by promises of future land sales that officials acknowledge may never materialize.
More than 400 billion yuan of municipal bonds sold since 2008 -- part of as much as 14.2 trillion yuan in local borrowing -- show how much local officials rely on their own forecast that land prices will continue to rise. Efforts by the central government to cool the property market so far have had no impact on their bullish estimates.
Residential land sale values slumped 30 percent this year as local officials increased sales to pay back loans, according to Credit Suisse Group AG. "It’s a huge myth that land sales are going to be able to even support the interest payments let alone the principal payments," says Stephen Green, the Hong Kong-based head of Greater China research at Standard Chartered Plc. His research team assumes that at least 4-6 trillion yuan of local government loans -- and possibly much more -- will ultimately not be repaid by the projects, Green wrote in a June 29 report on China’s debt.
Local governments set up more than 10,000 so-called financing vehicles in the past decade to get around laws prohibiting them from taking direct loans. One third of them don’t have cash flow to service their loans, China’s banking regulator says.
The similarities with special purpose vehicles in the U.S. hiding toxic repackaged mortgages from banks’ balance sheets are increasing. Subsequent losses prompted the U.S. government and central bank to lend, spend or guarantee a peak of $12.8 trillion in 2009 to rescue the financial industry, including a $45 billion direct investment to rescue Citigroup Inc., then the biggest U.S. financial services company.
‘Playing with Fire’
"It means that China is playing with fire like we played with fire when we had all those SPVs that took everything supposedly off the books," says Carl Walter, who retired this year as the chief operating officer in China for JPMorgan Chase & Co. "It didn’t take them off the books. Citibank went down."
Moody’s Investors Service puts overall local government borrowing at 3.5 trillion yuan more than the 10.7 trillion yuan stated in a national audit published June 27. China’s central bank on July 11 backed the official count, saying estimates of 14 trillion yuan were "obviously" too large.
Banks cannot restructure all the local government loans on their books, Yvonne Zhang, a Moody’s analyst in Beijing, says. Recapitalizing the banks by the central government will slow growth in the world’s second-largest economy, says Vincent Chan, head of China research at Credit Suisse in Hong Kong. The effects would reverberate around the globe in weakening the country’s appetite for U.S. Treasuries and European debt, as well as driving down prices of oil and metals, Fitch Ratings said in a June 28 report.
Touting Western Brands
The building binge fueled by this mound of debt is evident a few hours’ drive into the hills of Loudi from the provincial capital of Changsha. Cranes abound amongst new high-rise apartment complexes with names like Wealthy City, surrounded by billboards showing pictures of Caucasian women strolling through shopping malls featuring brands like KFC and Microsoft.
Loudi City Construction Investment Group Co. plans to use 21 percent of the proceeds from its bonds issued in March for the stadium complex and the rest for a new expressway into town, water treatment facilities and a park, according to its prospectus. The city is one of scores across the country building roads, commercial centers and subways after being urged to spend their way out of the 2009 global recession.
On a sunny day in early June, Yang smiles as he talks of transforming Loudi from an economy dominated by a single state- owned steelmaker into a bustling transport hub, a popular phrase these days with officials who tout projects they say will bring prosperity to their cities.
Set on a lush green hillside, Loudi will be a stop on a high-speed railway spanning more than 1,200 miles from Shanghai in the east to Kunming in the west, near the border with the Southeast Asian nation of Myanmar. "Every train will stop here," says Yang, in his downtown office at the company’s headquarters. A Mao statue with a red kerchief draped around its shoulders stands in the lobby.
Outside, Yang points to a vacant plot in a swathe of land already cleared and being drained to build apartment blocks. It’s one of the lots being used for collateral. The company has pledged to repay debt by selling land it received from the city, leveraging local land prices that doubled between 2007 and 2010, according to the prospectus. The 9.69 million yuan an acre it values its land for the bond compares with a tender price in May of 2.54 million yuan an acre for a city plot zoned for commercial use, according to data from the local State Land Resources Bureau.
Better Than Treasuries
Foreign ratings companies don’t assess China’s local bond market and domestic evaluations vary. Beijing-based Dagong Global Credit Rating Co. rates Loudi’s bonds at its fourth- highest investment grade, one level higher than it gives to U.S. Treasuries. That’s in spite of its own December 2010 report that said: "The city’s ability to balance the general budget is decreasing and the results of the sales of land use rights will impact the company’s ability to invest and do construction."
Dagong gives a high rating to the bonds of local government financing vehicles because the central government has said infrastructure debt will be repaid by local authorities, chairman Guan Jianzhong said July 11. Rapid growth in local fiscal revenue should enable them to pay debts, he said.
Loudi’s investment vehicle had a negative operational cash flow of 187.1 million yuan in the first half of 2010, a period during which it borrowed 284 million yuan. Beijing-based China International Capital Corp., often referred to as CICC, gives Loudi its third-lowest rating, a speculative or non-investment grade. The yield on Loudi’s bonds reached a record high of 7.318 percent on July 7, according to data from China Foreign Exchange Trade System. Yang, the official, isn’t worried. "When we get to the end of our loan we’ll just pay it back," he says.
Across China, cities increasingly turned to the country’s nascent bond market last year after the national government turned off the spigot for many bank loans. That’s propelled a six-fold increase in bond sales this year from three years ago, according to CICC, an investment bank run by the son of former premier Zhu Rongji. "We are forecasting a lot of local governments will have to default," says Jinsong Du, an analyst at Credit Suisse in Hong Kong. About one-quarter of China’s municipal debt is guaranteed with land sales revenue, Auditor General Liu Jiayi said June 27.
Mansions Among Smokestacks
In Cangzhou, almost 800 miles northeast of Loudi, on the shores of the Bohai Gulf, luxury apartment complexes are sprouting up in view of more than a dozen smokestacks at one of China’s biggest coal depots. A billboard for Leader Mansion promises, in English, that it will bring the buyer a "high degree of endorsement of a city life."
The city is expanding Bohai New Area, a port zone between Tianjin and the border of Shandong province, by building roads and developing unspecified "green" projects with 1 billion yuan in bonds issued in May by Hebei Bohai Investment Co. They’re guaranteed by five tracts of land the company says is valued at more than 1.54 billion yuan, or 462 yuan per square meter. That’s more than three times what it paid the local government in December 2009, according to the company’s land use permits viewed by Bloomberg News.
Ask Lu Chunjiang, a Communist Party member and head of the local investment company’s asset management department, where his assets are and he can’t say. "It’s somewhere north of town, I don’t exactly know where," Lu, 41, says in his second-floor office in Huanghua Port, built on saline marshes. "It’s like the land outside the city, you know, with the big piles of salt."
Inability to Pay
Hebei Bohai’s bonds were skewered by Xu Xiaoqing, head of fixed income research at CICC, in a May 26 report. "This issuer’s own profit and cash flow is very little, its cash shortage is extremely big, its debt load is very heavy, and it doesn’t possess the ability to pay this bond," Xu and his team wrote. The local government’s fiscal income "is very limited, there will be a lot of pressure on it to support the payment of this bond," they added.
Hebei Bohai’s long-term debt of more than 7 billion yuan at the end of 2010, before the bond was issued, was greater than the city’s annual revenue of about 5 billion yuan for that year, according to the prospectus. The debt-to-government revenue ratio was higher than that of Vallejo, the northern California city that filed for bankruptcy in 2008. Vallejo cited falling revenue from real- estate transactions as a reason for its bankruptcy.
Banks on the Hook
Banks including Industrial & Commercial Bank of China (601398) Ltd. and China Construction Bank Corp. (939), China’s two biggest by market value, may have problematic loans equivalent to 30 percent of their books, says Victor Shih, a professor at Northwestern University in Evanston, Illinois, who studies China’s local government debt.
The banks also are among the leading holders of China’s mushrooming corporate debt according to data compiled by Chinabond, China’s Beijing-based bond clearing house. This year, mutual funds have been the biggest buyers, according to CICC. They’ve snapped up half the corporate bonds issued in the first five months of this year, 70 percent of which were to finance local government projects.
Buyers are attracted to high yields and have faith that the central government will bail out any in trouble, says George Weisi Tan, head of bond investments at Fortune SGAM Fund Management Co. in Shanghai. "They think the interest is risk free," says Tan, who says some brokerages leverage themselves as much as three times their capital. "This is really a big systemic risk."
Such pessimism is overblown, says Nicholas Lardy, a senior fellow at Washington’s Peterson Institute for International Economics who specializes in China’s financial system. The buildup of debt is slowing and many local infrastructure projects will raise revenue and add to economic growth, he said. "A majority of the projects that are being undertaken by these companies are probably projects that have very high economic rate of return," Lardy says.
Wang Tao, a Beijing-based economist for UBS AG, wrote in a June 7 report that a crisis from bad local debt is "unlikely in the near future." Of most concern, she said, is borrowing obtained with no collateral at all.
That’s the case in Yichun, a Maryland-sized area of about 1.3 million people deep inside the birch and pine forest on China’s border with Russia. Yichun is a poor city in a poor province. Income of Yichun residents was little more than half the national average last year. That hasn’t stopped the government from going on a spending spree. The new local police headquarters has a miniature dome reminiscent of that on the Vatican’s St. Peter’s Basilica.
Yichun City Construction Investment & Development Co. sold 1.2 billion yuan in bonds in 2009 backed only by a pledge from the local government and possible future land sales. CICC gave it the lowest debt rating of any city financing vehicle. In contrast, Dagong rates the bonds one level higher than U.S. debt.
Money raised from the sale is being used for the destruction of what the prospectus calls "shanty towns." Single-floor traditional wooden homes in the vallrv ey are being demolished to make way for thousands of low-income apartments. The company has also financed a new reservoir, an airport terminal and parklands, one featuring faux Corinthian columns topped by winged warrior princesses and bronze sculptures of chariot-riding local gods.
Missing Chairman Mao
Wang Zhongbing, 77, a retired factory worker who spends the summer days chatting with friends in a park next to the Yichun River, says the economic development is passing his family by. Only one of his three adult sons has a job, he says. "I miss Chairman Mao," says Wang, sitting on a red plastic chair in front of a billboard for newly built Pinaster Town, featuring a picture of a woman in high heels stepping out of a Rolls Royce. "The common people cannot afford these houses."
The Yichun financing vehicle would have lost money every year from 2006 to 2008 except for direct government subsidies. At its offices above a local bank branch in the center of town, Sun Yunlan, 49, who according to the prospectus is deputy general manager of the company, referred questions to the city’s finance department, which, in turn, referred questions back to the company.
The prospectus promised that land from the city "will provide a more substantial cash flow." Two years on, that hasn’t come to pass, according to Wu Liangguo, the head of the Yichun City Bureau of Land and Resources and its Communist Party secretary. "The land market in Yichun isn’t that great," says Wu, 49, who jogs even in minus 30 degrees Celsius (minus 22 degrees Fahrenheit) chill of the Siberian winter. "The local government financing vehicle may get land in the future but it isn’t a certainty."