Mama mia

I’m a long way from the action sitting here in Newcastle but markets were off a little earlier this morning on news stories that the chances of a Greek default had rocketed up the ratings again. It seems that like any rational human being, European politicians are rethinking their stance on default given the ratings agencies have effectively said whatever they do is a default. So why not actually default and thus reduce the debt burden on the Greek people – particularly when they can’t get private investors to buy into their plan.

No doubt the spread of the contagion into Italy over the past couple of week’s and which intensified late last week will be one of the primary drivers of this new approach but its seems we might just get the lid lifted off Pandora’s Box after all.

The FT’s Lex column this morning wrote of the crisis and the spreading contagion:

If policymakers needed reminding that time is running out, the volatility of Italian markets at the end of last week offered a reminder. The yield on Italian 10-year bonds has risen by 65 basis points since the beginning of June, and, at 5.27 per cent, is at its highest for nine years – and only about 40 basis points lower than the yield on equivalent Spanish bonds. Shares of UniCredit, Italy’s most systemically important bank, have fallen 20 per cent since July 1.

Policymakers know that when 10-year bond yields go much above 7 per cent they quickly become too expensive for countries seeking market funding. Averting such destructive contagion should be the overwhelming priority. Rather than averting the inevitable in Greece, the urgent task now is to stop contagion spreading to Italy, Spain or Belgium.

For those of us who remember either the ERM crisis of the Early 1990’s or the Asian crisis later that decade this rolling European crisis has continued to work through the possible candidates for market attack and has succeeded in shining a light on the 3rd biggest economy in Europe – an economy that is just too big to save. Also, those of you who remember Malaysian PM Mahatir’s famous attack on the hedge funds will draw parallels with a Bloomberg report that today outlined similar measures:

Italy’s financial-market regulator moved to curb short selling after the country’s benchmark stock index fell the most in almost five months and bonds tumbled on investor concern Italy would be the next victim of the region’s debt crisis.

Reuters is reporting that European Council President Herman Van Rompuy has called an emergency meeting at which ECB President Jean-Claude Trichet and regional finance Minister head  Jean-Claude Juncker will both attend along with EC President Jose Manuel Barroso and Olli Rehn the economic and monetary affairs commissioner.

No mucking around with the attendees then – but too what end?

“We can’t go on for many more days like Friday,” a senior ECB official said. “We’re very worried about Italy.”

According to Reuters the negotiations on the French plan are at an impasse because the Germans, Dutch and Finns all want their banks and insurers to take some of the pain of helping out Greece. But this is being resisted by bankers. A senior official in the negotiations had said that negotiations were “back to square one”.

No wonder the markets are getting the willies about Italy. The overall lack of strategy that Europe is demonstrating in dealing with the problems of debt amongst the Club Med Countries and Ireland is poisonous. Anyone who has read economic history, whether told by Reinhart and Rogoff or others, knows that it is difficult to grow one’s way out of debt. This is certainly the case with the sorts of debt levels that many advanced countries are carrying. Specifically, they identified the 90% level, which is the red line in the chart above (data from OECD). Why 90%? Reinhart and Rogoff posit:

A general result of our “debt intolerance” analysis, however, highlights that as debt levels rise towards historical limits, risk premia begin to rise sharply, facing highly indebted governments with difficult tradeoffs. Even countries that are committed to fully repaying their debts are forced to dramatically tighten fiscal policy in order to appear credible to investors and thereby reduce risk premia.

The market can see the difficult tradeoffs and the inability of austerity (fiscal tightening) to give any reprieve to the fiscal position. Indeed we can all see that things are getting worse as austerity bites.

Markets in Asia haven’t, for once, taken this news and melted down. Sure the EUR is off around 0.5% and Asian stock markets and US futures are down but we aren’t seeing the panic we have in the past few months. We’ll have to see how this plays out. Italy is too big to save, we going to need a circuit breaker.

Link to a similar story in the FT for those who have a sign on:

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  1. “ratings agencies have effectively said whatever they do is a default.”

    I wonder which of the CDS buyers on Greek debt prodded the rating agencies to profess such a “credit opinion” at this late stage – this is akin to “match fixing” that we usually hear about in Rugby/Cricket – bet big on one side winning/losing and bribe one of the players.

    Where were the rating agencies in all these years when Greek government borrowed and spent like a drunken sailor?

    • Deus Forex Machina

      Yes, Houses and Holes and i were only talking on this very topic last Thursday as to what the ratings agencies were playing at being so aggressive…

      I wouldn’t suggest they are doing it for the benefit of hedge funds or others but I do think they are trying to take back the ascendancy and rebuild their somewhat shattered credibility

  2. On the rating agencies an American friend says the current shots at Europe keep the eyes off the US economy. I think there is some truth to that.

    • Deus Forex Machina

      Great link thanks…Munchau has been the thought leader on this crisis since the start.

      • The EU is in a lot of trouble for sure, but most governments have a scalable debt problem to some degree IMO. I wonder how many bankers and politicians have read “This time is different” as you refer to in the article?