Spain: Fifth Government in Periphery Falls

By Marc Chandler

This post first appeared at the Marc to Market blog

Spain is the latest euro zone country to change governments. Since the debt crisis materialized, Ireland, Portugal, Greece, Italy have new leaders. The exact vote is not clear and does not really matter for international investors. The important take away is that as expected the Popular Party (PP) won a clear absolute majority.

Rajoy, the new prime minister will be able to count 180-185 seats, according to the exit polls, of the 350-member chamber. As in the other changes in governments in the euro zone, Spain’s will electoral results do not signify a change in the basic agenda. In a word, austerity. Different personalities and different coalitions may be reflected, and on the margins this may benefit one special interest group over another, but throughout Europe, the political elites across the ideological spectrum have embraced austerity.

New governments in Greece and Italy have brought no real relief to the financial markets. There are forces in motion that are not about which personality or interest group is implementing the various austerity programs.

Spain is unlikely to prove to be an exception. The dynamics are essentially the same. The economies are deteriorating faster that the austerity is being implemented, resulting in the overshooting of deficit targets, which in turn necessitates more austerity.

At the same time, due to larger forces than any single country, investors are selling sovereign bonds. Much of the talk about the ECB as lender of last resort, in practice the ECB has been acting as a buyer of last resort from European banks. The selling of peripheral bonds is over-determined. It is a function bank reducing assets to meet capital requirements. It is about the loss of confidence in the European elite, after at least three times this year, promising a comprehensive package that turns the corner.

The selling of peripheral bonds is also a function of European officials wanting their cake and eat it too. Many financial institutions bought peripheral bonds and bought insurance in the form of credit default swaps. In the way the Greek haircut is being delivered and a credit event seemingly being avoided, does not sit well with investors.

There is another consequence of this ill-thought out strategy. It appears to have doomed the effort to leverage the EFSF by having it insure the 20-30% of new sovereign issue by some countries. It is as if after just undermining the legitimacy of the sovereign credit default market, the plan to leverage the EFSF entails that it essentially sells a limited default insurance policy.

This leaves the EFSF terribly under-capitalized even at this late date. The problem is not that Europe does not have the resources to address the debt problem, it simply lacks sufficient will. Even the Economist Magazine recognizes merit in the argument put forward here previously, suggesting that in a parallel to the abdication of territorial empire at the end of WWII, Europe must now pullback from its commercial expansion. It over-reached and now has to bring backs interests in line with its capabilities.

According to ECB data, as of the end of Q2, European investors had 4.86 trillion euros of direct investment outside of the euro zone, more than three quarters was in equity or retained earnings.

It had another 4.76 trillion euros of portfolio investment outside the euro zone, which was about 80 bln euros less than it had at the end of last year. This is a function of a reduction in the value of equity holdings as the value of the debt holdings were essentially unchanged.

The ideas floated in recent days about the ECB loaning money to the IMF to loan back to euro zone members is also seems dubious. Where will the ECB get the funds from? If it had to take a 50% haircut on its Greek bond holdings, its current capital base would be completed wiped out many times over.

Or course something worse, if a disorderly default on all investors comes to pass. The IMF’s existing resources are sufficient to provide a precautionary or flexible lines of credit to not only Italy and Spain but several other countries as well.

Some observers have not given up on ideas that China could still provide some assistance. One or two months of reserve accumulation will suffice. If Europe does not want to reduce its commercial reach, there is a way to entice China’s assistance. The EFSF, which struggled to sell its last bond, and the performance of its existing bonds do not exude confidence, is now reportedly considering bill issuance. If they want Chinese money, shouldn’t the EFSF consider issuing yuan-denominated paper ?

European governments, including Germany, issue dollar-denominated debt from time to time. Issuing foreign currency denominated paper does not have the stigma that it would in the US. The internationalization of the yuan has thus far been largely limited to trade settlement in Hong Kong.

Trade settlement has far outstripped Dim Sum bond issuance, which outside of a few marque international business names is largely dominated by the numerous arms of the Chinese government and financial firms, especially banks and property developers. A yuan denominated bond by the EFSF would be boost another characteristic of money for the inconvertible yuan, store of value.

In addition to a yuan-denominated EFSF bond, the governments of the periphery should consider another type of bond. A particular thorny problem lies in the fact that investors demand higher bond yields just at the moment in time where countries are less able to afford it. What is needed is an instrument that ties investors’ interest to the success of the country. Countries should consider bonds where the returns are tied to GDP.

When growth is good, the country can afford to pay higher interest and when the economy is in a recession it can’t. Conventional bonds are just the opposite. John Williamson, formerly of the IMF and offered the first articulation of the "Washington Consensus" as such, has long advocated such bonds for both developing and developed countries, including the United States

No discussion of debt can be concluded today without some reference to the US super committee. Its failure is imminent, barring some last minute Black Swan. The market impact is likely to be minimal.

Not only are developments in Europe more critical right now for the dollar’s exchange rate, but expectations had been low and seeming to decline in recent days. It is more embarrassing than substantively significant. The automatic cuts do not go into effect until after the 2012 election and even then are back-loaded. Congress needs to turn its attention to the expiration of the payrolls savings tax break and the emergency unemployment benefits.

Without a new positive agreement, the associated fiscal drag would offset most of the growth economists and the Federal Reserve expect next year. This of course keeps the door open to a possible policy response, but more immediately, recent US economic data has been sufficiently good to prompt a number of large US banks to revise up their Q4 GDP estimates.