Like A Dog Guarding His Bone

Presidents and Prime Ministers have to be careful with their choice of words. Especially in times of crisis and difficulty for their country. Former Mexican President José López Portillo will be remembered by history, not for his turbulent relations with his beautiful mistress Sasha Montenegro, but for the fact that one day after he appeared on national television stating "I will defend the Peso like a dog after its bone" the Peso was massively devalued. In similar fashion, when the Greek Prime Minister declares "Our national red line is to avoid bankruptcy," the markets do not know how to interpret him. Does this mean, they ask, the some form of debt restructuring is imminent? So the intervention this week of Spain's Prime Minister Jose Luis Rodriguez Zapatero, in a rather clumsy attempt to calm financial markets, could not have been more unfortunate. It is “absolute madness.” he told journalists in Brussels, to think Spain will need the kind of aid package debt-laden Greece is receiving from the European Union and the International Monetary Fund.

Of course it is, at least at this point in time. So why mention such a possibility? Right now what Spain needs is determination, leadership and serious reform. Mr Zapatero was reacting to market rumours that Spain was next in line for a rescue loan and was in the process of negotiating a €280bn bail-out package. The International Monetary Fund in Washington, for their part, confirmed that they will indeed be visiting Spain next week, but clarified that this simply formed part of a rountine annual consultation. There was no question of any rescue plan, and there the matter should have rested.

But something, somewhere had touched a raw nerve in the Spanish administration. Mr Zapatero said it was “simply intolerable” that such rumours were damaging Spain’s interests and could increase the cost to the state of raising money through bond issues. But his statement did little to improve things, since the country had to pay an average yield of 3.53 per cent on the sale of €2.35bn of five-year bonds later in the week. This was 72 basis points more than at the last five-year bond auction only a month ago, and the highest yield for the sale of new Spanish bonds over this maturity since May 2008. To put this in perspective, if matters continue in this way, the additional revenue anticipated from July’s VAT increase will soon be eaten up in added interest payments.

The root of the problem here does not lie in rumours, or inadequate perceptions of Spain’s situation among investors or “speculators”. The real problem is to be found in the levels of debt, whether public and private, which are to be found in many countries on Europe’s periphery, and in the ability of Europe’s existing institutions to handle the problems which have arisen.

And all of these concerns made themselves evident again on Friday, since despite the fact that many Eurozone countries have been busy getting parliamentary approval for the loans to Greece, the markets remain unconvinced that the rescue will work. Greek government bond prices fell sharply on Friday amid investor flight due to concerns the country might be forced to restructure its bonds in the coming days and weeks because of the deterioration in sentiment that was only made worse by the sharp fall in US stocks on Thursday.

As the Greek emergency has grown into a wider European sovereign debt crisis, so eurozone governments seem to have arrived at the conclusion that changes to the design of European monetary union can no longer be postponed, and this topic will surely be the main item at their Brussels meeting this Friday evening. Details of the kind of changes which may be under consideration remain scant, and it is still far from clear that Europe's leaders are ready to accept just how thoroughgoing the institutional changes may need to be if they are to be capable of putting the common currency on a sound and sustainable footing.

Greek 10-year bond yields rose to a record 12.287 per cent on Friday, while the cost to insure the country’s bonds against default rose close to 1,000 points, a level widely considered to be an indicator that a country or institution is in danger of default. Portuguese 10-year bond yields also rose to 6.18 per cent, another record, while the cost of protect Portuguese debt jumped to over 500 points. This situation is already causing all sorts of anomalies, with Portugal, for example, facing the problem of having to lend Greece emergency loans at rates (5%) which are lower than what it would have to pay to borrow the money in the capital markets itself.

So confused was the situation on Friday afternoon that even the European Central Bank found itself repeatedly pressed on rumors that it was considering a special credit line for European banks. The focus of attention was a suggestion that the ECB might announce a special 12-month loan facility amounting to as much as EUR 600 billion over the weekend. This speculation followed strong market disappointment that no clear strategy had emerged from the monthly meeting of the central bank on Thursday. The news that three-month U.S. dollar Libor rates jumped 0.05 percentage point to 0.428% on the day simply added to concerns, since it suggests that demand for dollars in the European banking system is on the rise.

The report comes amid growing concerns that European banks face another liquidity crisis due to the widening sovereign debt crisis. Tension may well come to a head in July after the ECB's 12-month money tender expires, when banks will be expected to return to the interbank market for funding.

But in what is begining to look horribly like a repitition of what happened in the autumn of 2008 Europe's wholesale money market is starting to show signs of increasing stress, relieved only by the fact that European Central Bank is still offering unlimited liquidity to the system, if only for one week at a time. One small datapoint attracted a lot of attention among market participants on Wednesday: the 2 year German bund spreads was trading below the 3 month euribor. The last time that happened was right before Lehman Brothers went down in October 2008. No wonder everyone was so jittery on Thursday when someone made a trading error. And use of the ECB deposit facility to store cash has been rising. It rose to 290.01 billion euros on Thursday, up from 1.99 billion euros on Wednesday, according to ECB data, offering us an indication of the extent to which banks prefer to bolt-hole their money over at the ECB rather than lend to each other.

So the real confidence issue at the moment does in fact revolve around Spain. But not around Spain’s public debt, which is still small by European standards. Rather the crisis of confidence turns on whether or not Spain’s banking system will be able to find sufficient funding in the interbank market to satisfy its liquidity needs according to the exit schedule (still formally in place) laid down initially by the ECB.

In Spain itself the problem is that with the country’s’ leaders constantly denying there is a public debt problem while avoiding addressing the private debt issue, there is a real danger that confidence deteriorates even further, especially given the large quantity of public and private debt due for renewal in July. “We can’t spend all day paying attention to speculation,” Mr Zapatero said in Brussels. Exactly. Then don’t do it. What Spain’s Prime Minister needs to learn to do is stop answering questions people aren’t asking.

As for Europe’s leaders, the time for talking and the time for waiting is now over. What Europe needs is action. Action to convince the markets that they have the policies and they have the will to make the institutional changes that are needed to make the common currency work effectively. Since if they don’t, or if they can’t, then like President José López Portillo before them they may find the dog that can only bark and never bite very rapidly loses possesion of his bone.