Trichet and the Dubai spectre in low-speed Euroland

Posted by Gwen Robinson on Dec 04 09:43. Comment.

With the Dubai noise over the past week, it is worth asking where similar debt concerns might suddenly shock markets, says CLSA’s Christopher Wood in his Greed & Fear newsletter. The most vulnerable, in his view, More…
With the Dubai noise over the past week, it is worth asking where similar debt concerns might suddenly shock markets, says CLSA’s Christopher Wood in his Greed & Fear newsletter. The most vulnerable, in his view, remain the fringe parts of Europe - namely, Portugal, Italy, Ireland, Greece and Spain (sometimes known collectively as the PIIGS) - where bond yields spreads have begun rising again in recent weeks.
Indeed, such concerns are clearly haunting the ECB’s Jean Claude Trichet, despite his Thursday announcement that the next — and final — instalment of funds for banks would not be fixed at an ultra-cheap 1 per cent but indexed to future changes in the main policy rate.
Even so, as BreakingViews puts it on Friday, the ECB’s president could hardly have been more keen to stress that this did not signal any tightening in monetary policy. Liquidity, the central banker said, would remain “extremely abundant”.
Cleary, the ECB’s overriding concern is the weakness of Greece, Ireland, Portugal and Spain, and the prospect that their sputtering economies may stall. Afterall, notes BreakingViews, the eurozone’s annual broad money growth dropped lower in October, to just 0.3 per cent, and while eurozone lending to households rose in both September and October, it is down year-on-year, as is bank lending to non-financial corporations.
Eurozone companies rely heavily on banks, rather than capital markets, for funding, so the weakness in lending does not augur well. Rainer Bruederle, Germany’s economy minister, warned this week that German firms face a credit crunch. Concludes BreakingViews (our emphasis):
Following Dubai World’s unpleasant surprise, the markets are looking with more nervousness at Greece’s financing needs. Ireland, deep in deflation, is cutting spending hard. The level of financial frailty varies. But from Germany to Greece, the only eurozone fizz is in financial markets, not in real economies. Trichet and his team look like staying in the loose policy camp throughout 2010.
Meanwhile, warns CLSA’s Wood, the average spread of 10-year government bond yields in the PIIGS over German bunds has risen from a recent low of 85bp on November 12 to 116bp on November 26 and 106bp on Wednesday. And CDS spreads on the “weak underbelly of Euroland” have also been rising again with Greece leading the march upwards. Wood continues (our emphasis):
Thus, Greece’s budget deficit is expected to reach 12.7% of GDP this year, more than four times the EU deficit limit of 3% of GDP, while the country’s gross government debt is forecast by the European Commission to rise to 125% of GDP next year. It is also worth noting the growing divergence between the PIIGS CDS spreads and those of Germany. Greece’s five-year CDS spread has risen from a recent low of 100bp reached in August to 208bp on November 26 and 171bp at present, while the CDS spread on German bunds was virtually flat over the same period at 22bp.
“Fortress Euroland” has so far withstood the pressures of last year’s global financial crisis. But in Wood’s view, it is “premature to declare victory”. He concludes:The Baltic states remain a high-stress zone going through dramatic GDP contractions. Estonia, Latvia and Lithuania real GDP fell by 15.3%, 18.4% and 14.2% YoY respectively in 3Q09. While as with Abu Dhabi, it remains unclear if Germany is really willing to bail out the PIIGS 100 percents on the dollar if government debt concerns come to a head.
Meanwhile, it goes without saying that the euro is now supremely overvalued to the benefit of Asian exporters to the Euroland region. Clearly, the euro can get more overvalued so long as the rally in risk assets continues funded by the US dollar carry trade. That means mounting pressure which Euroland can do little about given its complete lack of credibility at the political level.

Related links:The ECB goes for indexation - Money-Supply blog
Euro boosted by ECB liquidity signals - FT
ECB spurns IMF with early exit strategy - FT
PIIGS to S&P slaughter - FT Alphaville.