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.

Spain's Unemployment Problem

Well, according to a popular urban legend, Spain's unemployment rate - which is the second highest in the EU after Latvia - is currently running at something just a touch over 20%. Or is it? The unemployment problem I wish to address here is not the one of how to get to grips with actually putting all these people back to work, rather it is that of untangling what exactly Spain's real EU harmonised unemplyment might be, since, to say the least of it, some strange things have been happening in recent months.

But to start with some consensually grounded facts: The number of unemployed jumped by 286,200 during the first three months of the year - using the not seasonally adjusted labour force survey methodology - and hit 4.61 million or 20.05 percent of the workforce, as reported in the conservative Spanish newspaper ABC on Tuesday of last week. And how did ABC know last Tuesday that the first quarter unemployment rate was 20.3% given that National Statistics Office (the INE) was not due to publish the official figures till Friday. Well ABC knew the number since the figure was "accidentally" posted on INE's web site for several minutes on Monday. The incident - which is reminicent of the Mr Bean interpolation on the EU Presidency Website at the Moncloa in January - was subsequently confirmed by the INE itself, who issued a statement baldly stating that a technological "incident" had made "certain data" from its quarterly unemployment study visible on its web site.

Of course, in a country as given to conspiracy theorising as Spain is, this "technological incident" has lead to all sorts of speculation - that, for example, statistical staff at the INE (in a similar fashion to those employees in the statistical office in Argentina's Mendoza province who rebelled against Nestor Kirchner's use and misuse of inflation numbers) had simply gotten tired of seeing their data massaged for political objectives, and wanted to get the politically sensitive 20%+ number published before it was changed. Indeed none other than Economy Minstry Secretary of State José Manuel Campa had to come out publically to deny that anything untoward had happen.. As far as the Ministry was concerned there had been no leak. "The Employment Survey data was not leaked", he said "there was an error. There is absolutely no evidence that the information was leaked. Spanish insititutions are quality ones. To create doubt about this seems to me to be a major act of irresponsibility. I am convinced that mistakes can be made."

Unsurprisingly, there are many who remain unconvinced. "It is becoming clearer with every passing day that what happened on Monday was not an accident, but was a leak to try to ensure that the data was not manipulated even more," declared the conservative newspaper Hispanidad. "Fortunately", they went on to say, "in our statistics office we still have professionals who are not willing to accept just any old methodology" .

In fact, just this week the mystery (or war of leaks) deepened even further, since data apparently leaked on Saturday by government sources to the EFE news agency showed that the number of unemployed registered at government agencies (a different methodology) fell by a non seasonally adjusted 24,000 in April. The data was not scheduled for release until tomorrow (Tuesday).

Now a lot of this would be none-to-worrying, and might seem like a lot of the typical to-ing and fro-ing you tend to associate with normal political debate about unemployment, except, except.... well except that something rather strange does actually seem to have been happening, and except that, well, you know, there is rather a lot of concern around about the level of Non Performing Loans in Spain's banking system, and the econometric equation used by both the Bank of Spain and the IMF (more on this in another post) for their stress tests, well, the assesment is based on projections about Spain's actual unemployment rate. So there is more than just votes at stake here.



What, then, has been going on? Well the first thing that I find strange is the fact that the unemployment numbers do not really fit with other indicators we have, like the number of people affiliated to the national social security system - which is, if you want, a measure of the number of people actually employed. Basically since last September, when you could say that the funny things happening with Spain's unemployment data got even funnier, a seasonally adjusted 189,000 people have stopped contributing to the social security system (by March, see above chart). This represents something like 1.06% of total employment, so how the hell, we might like to ask ourselves, can estimated unemployment have only risen by 0.1%? Especially when, and according to the Labour Ministry's own data, the economically active population has risen by a seasonally adjusted 35,000 over the last six months. Something, somewhere just doesn't fit here.

Especially if you look at the chart I have made of the Eurostat data as it now stands, where it seems unemployment has been completely flat for several months.



Now, since I have been very irritated by this whole situation for some time now, with the data filed at Eurostat being constantly revised, I decided to do that really tedious and tiresome thing, and go back through all the relevant press releases from Eurostat. If you want to check for yourself you can go to this page, where you will find the entire file, complete with the relevant links.

Here, for the sake of convenience, I will just produce two extracts, the latest (March) data, and the data for November 2009. (Please click on images for better viewing).

Now, as can be seen in the November file (below), unemployment had been rising steadily at a more or less even pace since the spring, and had hit 19.4% by November, which made the sort of predictions that I personally was making for unemployment going up towards the 25% mark in 2010, if not completely scientifically valid, at least not simply wild speculation.



But if we now move on to the March 2010 file (below) we will see that the 19.4% level was never actually hit (in theory), and that unemployment is supposed to have peaked at around 19% of the population, and is now, of course, about to turn down.



Of course, they may have some problems with the seasonal adjustment methodology, but in which case they should say so. On the other hand, the social security affiliates data suggests a constant employment loss of around 35,000 a month for the last several months, and that the bloodletting continues relatively unabated, which means Spain is experiencing a "real" increase in its unemployment rate of around 4% a year. And if you then apply this input to a simple linear regression model based on earlier Spanish data (which gives a factor of 0.66 to apply to this percentage rate of increase), then we might reasonably expect the rate of distressed loans to go up by something like 3% this year.

The IMF Global Financial Stability Report on the other hand, using face-value unemployment data (see this file page 54) projects NPLs at commercial and savings banks will peak at 6.3 percent and 6 percent, respectively, in 2010:Q3, and then come down to 5.1 percent and 5 percent, respectively, by the end of 2011. That is really the importance of this whole debate, since (assuming other things to be equal, which in fact aren't but we'll see about that another day) if unemployment hasn't yet peaked, then NPLs won't peak in Q3 2010, or anything like it, as the authors of the IMF report themselves point out in their adverse case scenario.

Now, there is another possible explanation for the mismatch between unemployment and job loss, and it is one that I have explored in this post here in my blog on the Spanish newspaper Expansion: it could simply be the case that people - both young Spanish nationals and migrants - have left Spain.

What A Difference A Day Made!

According to a once famous statement by the British Prime Minister Harold Wilson, a week is often a long time in politics. But when it comes to financial market crises we seem to follow a pattern more reminiscent of a line from the Dinah Washington version of an old María Méndez Grever song: "What a difference a day made". The day in this case was last Wednesday, at least for those of us here in Spain, since it was on Wednesday that the ratings agency Standard & Poor's downgraded Spanish Sovereign debt to AA from AA+. As a result the cost of insuring such debt using credit default swaps (CDS) surged at one point to a record 211 basis points according to CMA DataVision prices. Contracts on Greece and Portugal also rose sharply, with Greece climbing 42 basis points to hit 865.5, while Portugal jumped 20 to 406.

Standard & Poor's justified their Spain downward revision by referring to their medium-term macroeconomic projections. In particular the agency cited heavy private sector indebtedness (of around 178% of GDP), an inflexible labor market (they expect unemployment to remain around 21% throughout 2010, but then continue at a very high level for half a decade or so), the country's fairly low export capacity (Spain's exports only amount to around 25% of GDP) and the general lack of external price competitiveness. All these factors they feel are likely to mean that Spain will have low growth between at least now and 2016, a factor which will make the combined burden of private and public indebtedness much harder to service.

And despite the fact that Spanish Deputy Finance Minister Jose Manuel Campa stepped forward to say he was “surprised” by the move, arguing they are based on overly pessimistic growth forecasts, the fact is it is very hard to disagree with the S&P conclusions, as investors across the globe well understand. Even the EU Commission recently responded to Spain’s Stability Programme by stating that the growth forecast it contained was far too optimistic, and the IMF are even more pessimistic than the Commission.

In fact, it now seems that the present Spanish government seems to be becoming more and more isolated from Spain's financial and corporate establishment with every passing day. As Victor Mallet points out in today's Financial Times, "it cannot be often that academic economists use pictures of Omaha Beach, site of the bloodiest fighting in the 1944 Normandy D-Day landings, to illustrate their conclusions about one of the world’s medium-sized industrial economies", but this is precisely what the prestigous Barcelona-based Esade business school's latest economic bulletin did in their “H-Hour for the Spanish economy” editorial. “The diagnosis is very serious,” they said. “This is a highly indebted country with a damaged income-generating mechanism.”

Now even if one does not entirely go along with the whole analysis they offer of the roots and remedies for Spain's malaise, there can be no doubt that they now take the situation very seriously, even if one could lament that they did not begin to do so starting in August 2007, when the wholesale money markets first closed their doors to the increasingly toxic products that were being issued from within the Spanish banking system. The warning signs were already there, and were plain to see, although, unfortunately few inside Spain were able to do so. As a result, nearly three critical years have been lost, dithering around, large quantities of public money have been wasted, and what was a private sector external indebtedness problem has now been transformed, little by little, into a fiscal crisis of the state.

If the Spanish economy is really to be put straight, and not simply go straigh back and recidivise (after whoever it is who will do the "bailing out" finally does it), then surely one major priority during the coming national soul-searching process must be for public opinion leaders to find the ability and the courage to speak openly and clearly about the Spanish economy's "inner secrets", and the strength of character needed to publicly recognise problems in order to be seen to address them in a proactive and not a reactive fashion - to be out there in front of the curve, and not constantly trailing behind it. Put another way, it's high time Spain's bank and financial analyst community finally came out of the closet.

And if that all important international investor confidence is to be once more regained then it is important that those in the Economy Ministry are seen to be aware of the problems they face, and not simply reduced to the role of "marketing department" for a government which finds itself in ever deeper difficulty, caught between the rock of its own voters, and the hard place of the international financial markets. If you don't like having rating agency downgrades, then do something to avoid them before they inevitably come. But what was it Mr Zapatero was saying only yesterday, oh yes, he personally can see "signs" the Spain's economy Spain is at long last "improving", that the "worst is now behind us", or as Miguel-Anxo Murado so ironically puts it in the Guardian's Comment Is Free: "all repeat after me, "Spain is not Greece"". I'm not sure who it is the Spanish Prime Minister currently has interpreting the signs for him - it is certainly not Perdro Solbes, or David Vergara, or Jordi Sevilla, or indeed Carlos Solchaga - but it seems far more likely to me to be one of Spain's renowned Gypsy palm-readers than any reputable and internationally recognised macro economist.

In fact, as I have often stressed (and as Paul Krugman makes plain yet again here) Spain's problem is not essentially a fiscal one. Spain's problem is one of very high levels of corporate and household debt, and how Spain's banking system is going to support these during the long economic downturn and the ultra-high unemployment the country now faces, especially as a growing number of unemployed steadily lose their entitlement to unemployment benefit. The problem is not only that unemployment is currently running at 20%, but that benefits only last two years (plus an emergency six month flat rate 426 euro monthly payment extension), while many forecasts are now showing unemployment in the 16% to 20% range in 2013 or 2014. Just how are all these people going to continue to pay all those mortgages?

So it is not simply that "public sector borrowing is aggravating external debt and leading Spain towards high-risk territory". This is happening, as Spain's most high profile and most strategic export increasingly becomes government and bank paper, but this is the aggravating factor, and not the root cause. The principal reason why Spanish debt is steadily moving into high risk territory is the continuing state of denial to be found among the Spanish decision making elite, and the absence of any credible plan that is up to the magnitude of the challenge ahead. Confidence has now become the main problem, but not the confidence of those consumers who rationally decide to keep their money in the bank (to earn those very attractive 4 percent interest rates those banks who now anticipate having difficulty funding themselves in the wholesale money markets are offering) rather than going out and spending it.

The real issue is to be found in the confidence (or lack of it) those who Spain and its banks owe money to that the country (as a whole and not just the government) is going to be able to pay it all back. And in this context the sea change in mentality that Victor Mallet describes - assuming it is maintained - will be crucial. Those of us with rather longer memories - ones that stretch back to January for example - may wonder whether, once the immediate pressure is off, all that new found national resolve may not simply drift back into the mists from which it emerged, as has happened only too often in the past. Maybe the simplest and quickest way to help everyone feel comfortable that this was not going to happen would be to call in the IMF now, not becuase a bailout loan is needed yet, but as David Cameron is suggesting in the UK case, to carry out a "no holes barred" policy audit, so that everything which should be transparent actually is.

Who Really Likes Having A Dose Of Ebola


Of course the problems which became all too apparent on Wednesday went well beyond Spain. Along with the CDS prices, bond spreads widened all across the European periphery - with Spanish, Greek, Portuguese, Italian, and Irish yields all widening in tandem. Yields on Greece's two-year bonds briefly even hit an incredible 21%, following Standard & Poor's downgrade of the country's sovereign debt to junk status the day before.

All of this and more finally forced the EU’s hand, and officials had to go rushing to the microphone to reassure investors that Greece would soon be able to access an aid package, with German Chancellor Angela Merkel going so far as to state that talks about providing aid should now be accelerated.

Then the numbers started to be filtered out, and evidently they were much larger than many had been expecting. According to press reports IMF chief Dominique Strauss-Kahn told German policymakers that Greece might need EUR120-130bn over three years, a number which the German press quickly calculated would mean that the German contribution might then go up to EUR25bn.

Certainly, at the point of writing we still don’t know what the exact number will be - and it is not even sure they have decided yet - but the reality is that once the EUR120-130bn number is out there from an authoritative source, it will be hard not to hit it, if not exceed it.

Then followed the announcement that IMF staff have reached an agreement with the Greek authorities on a 3-year program that will include draconian fiscal cuts (of the order of 10pc of GDP) and a series of structural measures aimed at driving nominal wages lower, reforming the pension system and building better institutions. Thus, the message this weekend to investors is: stop worrying about Greece for the next three years; you can continue to speculate in the secondary market, but the Greek government will be fine. And debt restructuring with the private sector now seems to be off the table for, at least for as long as the Greek government stick with the conditions – which will obviously be the aspect to watch carefully going forward. And even if there is an eventual default, the main counterparty will be other European governments (and the taxpayers who back them) and not private bondholders.

On the other hand, Europe’s institutions have, at a stroke, opened themselves up to a large slice of what is known as “moral hazard”, since the implicit message is : what we are doing for Greece we'll do for any other Euro-zone country, if needed. So from this moment on, we are all in up to our necks, if not beyond.

This "historic moment" point-of-no-return dimension did not escaped the notice of Dominique Strauss-Kahn either, since following his meeting with German politicians he was at pains to stress the potential contagion affect lack of backing Greece to the hilt would have had on the euro and the rest of Europe in the days to come. “I don't want to hide behind a rosy picture. It's not easy,” he said. All this “ can also have consequences far away. We have to face a difficult situation. We are confident we can fix it... But if we don't fix it in Greece, it may have a lot of consequences on the EU.”

Highly respected US economist and Harvard University Professor Martin Feldstein went even further, saying that in his opinion Greece will eventually default on its bonds and he feared other euro-area nations may follow, most probably Portugal. “Greece is going to default despite all the talk, despite the liquidity package,” he said. Portugal's name is mentioned frequently these days, since although the government deficit and debt levels are lower in Portugal than in Greece and the Portuguese government has much more fiscal credibility than its Greek counterpart, when you add private sector debt to the public part the number is not far short of 300% of GDP, and in fact the underlying problems are very similar to those which are to be found in Greece.

But it isn’t only in the South the the EU has to worry, since probems in the East continue to fester. The Hungarian forint had a fairly hard time of it over the past few days, and had a two-day intraday loss 3.6 percent on Tuesday and Wednesday, its biggest such fall since March last year. At the same time the cost of credit default swaps on Hungarian debt rose 23.5 basis points to 240. The drop followed revelations from Hungary’s incoming Prime Minister Viktor Orban that the country’s underlying fiscal deficit had in fact been rather higher than the previous government had acknowledged. So contagion may now be also moving Eastwards, meaning that EU institutions may now increasingly face a battle on two fronts, since the wobbling won’t simply stop with Hungary, there is Latvia, Bulgaria and Romania to also think about (just to name the first three that come to mind).

As Angel Gurria, OECD Secretary General, said this week: “This is like Ebola. When you realise you have it you have to cut your leg off in order to survive...... it is contaminating all the spreads and distorting all the risk assessment measures. It is also threatening the stability of the entire financial system.”