Spiking skywards? Tackling rising yields in the Eurozone
The Eurocrisis is once again dominating the headlines. Renewed talk of a Greek exit, record yields for Spanish bonds and rising Italian borrowing costs have been splashed all over newspaper headlines. This week Spanish bond yields reached new record highs breaching the 7% level for maturities of two years and above. Italian yields too were trying new highs.
Then the president of the ECB spoke saying that the ECB would do "whatever it takes" to save the Euro. The markets reacted positively and yields fell. There is an expectation in the markets that policy makers may come up with some new measures to address the spiking yields soon. We are much more sceptical both of their immediate intentions to enact more measures and their ability to bring the yields down sustainably. One could hardly expect the president of the ECB to not say that he would do whatever it takes to save the Euro. This Policy Brief addresses two questions 1) why are spiking yields a problem? and 2) what are the near-term options for bringing these down.
The Spanish Donkey, a feared torture device from the middle ages, consisted of a wedge on which the victim was seated with weights tied to his or her legs so that with enough weight, the wedge could even slice though the victim’s entire body. Arguably, the Spanish economy now sits atop such a wedge weighed down by deep austerity measures and unprecedented unemployment on the one side and by large unknown losses in the banking system brought about by a real-estate bubble that has burst on the other.
What is worse is that these two aspects weighing the economy down reinforce each other in a manner that is clearly not understood that well by EU policy makers. The Spanish economy today is at a point where every bit of austerity, measured in percentage points of GDP, leads to a reduction in demand that is even larger. So a 1% cut in government spending is likely to lead to a fall in GDP that is larger than 1%. This is because the uncertainty over the future of Spain and the fact that tomorrow, at this point, looks worse than today mean that neither consumers nor businesses are spending so a reduction in government spending translates directly into lost demand in the economy. What’s worse is that the expectation of falling GDP that accompanies such austerity means that both consumers and firms will make further cutbacks to their consumption and investment plans.
After Spain, it’s Italy’s turn in the Eurocrisis spotlight. The immediate cause for this spotlight is a two notch downgrade of the Italian sovereign by Moody’s, a rating agency from A3 to Baa2, just two notches above the dreaded junk status. Despite the downgrade, Italy is not Spain and the fact that the downgrade had a rather limited impact on the pricing of Italian bonds issued in its immediate aftermath reflects some of its fundamental strengths.
Nevertheless, expect this to generate a barrage of strongly worded public criticisms from European leaders, but the truth is that they only have themselves to blame. The single biggest factor weighing on the Italian economy at present is the uncertainty about whether or not the Eurocrisis will be resolved. And it is this, rather than Italy’s own domestic situation (which is also complicated), that is the most serious problem.
The terms of Spain's bank bailout are being finalized and this draft memorandum is a near final verison that lists the timeline and details of how this bailout would be conducted. While the draft looks rather comprehensive on first glance and does have several positive elements, it is also afflicted by a number of glaring omissions.
The first of these is that the memorandum fails to understand or acknowledge the link between the macroeconomic policies being pursued by Spain, for example on cutting its fiscal deficit, and the stability of the financial sector. In fact, many of the new austerity measures adopted by Spain will undermine the objectives of its bank bailout program. It also fails on take note of the social and political realities. Crucially, it makes no reference whatsover to the direct injection of equity by the European crisis funds, now or in the future.
The last sentence of the European Council Communique from the June meeting simply states “We task the Eurogroup to implement these decisions by 9 July 2012.” This was always going to be a stretch and as expected the marathon 10 hour meeting of the 9th of July has failed to do any such thing as is clear from the Eurogroup communique.
As we discussed in detail in our report following the European Council, there were four important decisions taken that day. Some of these, such as the decision to set up a Eurozone-wide bank supervisor, the decision to allow Eurozone crisis funds to directly inject equity capital into troubled banks in member states got a lot of people excited. However, as we discuss in this commentary, the Eurogroup meeting provided a good reality check for those who may have got carried away after the better than expected (only because expectations were managed so low) results from the European Council meeting in June.