The downward spiral

Does Spain have the luxury of not considering de­fault? Is the eurozone strong enough to exist post a Spanish default? Let us rewind to late 2011 when Mario Draghi announced the first Long Term Refinancing Operation (LTRO) which raised approximately €460 billion in funds for banks. More recently the European Central Bank provided a second tranche of LTRO which raised approximately €550 billion, taking the total figure to just over €1 trillion. Without going into too much detail, the purpose of this exercise was to provide banks with an easy way to make money by providing cheap capital which would allow the banking industry to make a margin almost risk free.

The gap within this ‘logic’ is becoming more and more obvious- Karl Micallef

Earlier this year, this LTRO programme seemed to address the market’s concerns with respect to the rising European sovereign yields (because some of these banks made the possible mistake of buying sovereign debt). This may have created a potentially false comfort zone. In a matter of a couple of months, the market has crossed the entire probability spectrum; starting from talk that Spain is set on the path of recovery, to the other extreme of discussing either a possible Spanish debt default, or yet another gigantic bailout to avoid this default.

The market is currently behaving like a light switch, either on or off; rather than a dimmer switch which would slowly shed more light (and hope) as the economic environment improves. It is important to remember that the financial problems of the “PIGS” are still real and present. Their debt levels may not be growing at alarming rates but they are definitely very far from shrinking in size. Even if the latter is achieved, this should not be enough. The end objective must be to achieve multiple years of surplus, which will reduce the overall debt levels that have accumulated over numerous years.

Spain is our current best example – this country is particularly important because sovereign trouble within would quickly have a ripple effect on other peripheral eurozone countries, such as Italy and Portugal. Furthermore, related banking problems would rapidly infect the rest of Europe and even the US. This scenario very quickly depicts the actual, real, European economic picture which is far from rosy. Earlier this week we saw the 10 year Spanish bond yield hit 6.17 per cent exceeding the all important six per cent level which is deemed to be the maximum cost afforded before Spain is deep into the red zone. Spain’s Prime Minister, Mariano Rajoy, agreed with the EU to cut the deficit figure from 8.5 per cent to 5.3 per cent of GDP. The markets can now move on and feel less fearful given what Mr Rajoy has just announced!

The part that really puzzles me is that a country which may be on the verge of defaulting is in fact aiming to achieve the grand result of a lower deficit to GDP figure. I would have thought that at this point it would be appropriate to start speaking about a few years of budget surpluses (and not smaller deficit numbers). But surely the politicians and EU technocrats know better!

Spain’s mammoth sized challenges have taken centre stage within this next chapter, entitled “The crisis even post LTRO”, of the eurozone crisis, replacing those of Greece. Unemployment in Spain is near 24 per cent and youth unemployment is over 50 per cent and in order to improve this, Spain is supposedly applying a strict austerity budget to shore up investor confidence. The gap within this “logic” is becoming more and more obvious.

It’s a vicious circle. The eurozone provided funds to banks (through LTRO) which used most of these funds to purchase sovereign debt at a time when the increase in yields was making it difficult for countries like Spain and Italy to finance their debt. However, the austerity programmes being implemented are slowing many European countries so much that the market is wondering whether countries like Spain will have sufficient revenues to meet their bond debt obligations. This has the perverse effect of reducing the value of the sovereign bonds held by banks thereby weakening their ability to lend to enterprise, which in turn further hurts the economy and fuels the downward spiral.

Curmi & Partners Ltd are members of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Any opinions that may be expressed here above should not be interpreted as investment advice, nor should they be considered as an offer to sell or buy an investment. The company and/or the author may hold positions in any securities that might have been mentioned in this report. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

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Mr Micallef is an executive director at Curmi and Partners Ltd.