Friday, August 5, 2011
An attempt by Europe’s central bank to contain the rapidly deteriorating sovereign debt crisis backfired spectacularly Thursday, helping trigger a plunge on global stock markets and compounding threats to the world economy.
With banks in the eurozone ever more reluctant to lend to one another, ECB President Jean-Claude Trichet announced an injection of liquidity with a resumption of its program to purchase sovereign bonds. But the apparent exclusion of Italian and Spanish debt from that intervention stunned stock and bond markets in Europe.
“This is quite a dangerous phase,” said Jamie Dannhauser, senior economist at Lombard Street Research in London. “Market disruption yesterday and today looks as severe in Italian and Spanish bond markets as anything since Lehman Brothers.”
With the eurozone inching closer to an all-out currency crisis, and with bond yields in its third- and fourth-biggest economies at 14-year highs, investors are clearly concerned that European officials will be unable to backstop Italy and Spain from being claimed by the debt crisis.
“It’s not as deep a crisis yet as would be required to move the ECB in that direction. It would have to be convinced that the euro was about to come apart at the seams,” said Stephen Lewis, chief economist at London’s Monument Securities, a turn for the worse he predicts is as little as a week away.
That reality is dawning on markets, Mr. Lewis said. Stocks in London, Paris and Frankfurt lost more than 3% Thursday, while Madrid fell 4%, and Milan by more than 5%.
Eurozone leadership has failed to grasp the urgency warranted by the escalating tensions, Mr. Lewis said. “They’re all at the beach. They had their summit and all took off for their holidays.”
At that July 21 summit in Brussels, in addition to a second bailout package for Greece, eurozone leaders enhanced the €440-billion rescue fund, or the EFSF, with the ability to buy bonds on the secondary market and extend short-term lines of credit to troubled sovereigns.
But those new powers will not come into effect for a number of months, leaving the central bank as the lender of last resort for the time being.
At a crossroads of the debt saga, that “leaves the EU’s safety net woefully inadequate against the growing market contagion,” Lena Komileva, global head of G10 strategy at Brown Brothers Harriman, said in a research note. She called for an extraordinary international intervention to stem the risk of a “self-fulfilling investor panic” of the kind witnessed after Lehman Brothers collapsed in 2008. “The global market stresses are now at levels that warrant such action,” she said.
The focus of those stresses shifted abruptly in recent weeks from Greece to Spain and Italy, which also wrestle with massive sovereign debt burdens.
Yields on 10-year bonds recently rose well past the critical 6% threshold in both countries, while capital flows between banks began to dry up as financial institutions park more and more money in low-interest deposits with the ECB.
“This is a further breakdown of the interbank system in the eurozone, whereby strong banks simply hoard the liquidity they’re receiving,” Mr. Dannhauser said.
Banks in Italy and Spain are now finding it difficult to borrow, feeding worries the sector could fall into a cycle of credit contraction.
But to have the capacity to buy up large chunks of Spanish and Italian debt if required, the EFSF would need to increase by four or five times, Mr. Dannhauser said.
That kind of decisive action, however, seems unlikely, given the deep divisions among the eurozone’s member states, including German opposition to any additional bond-purchasing, he explained.
“The problem is that because at each stage of this crisis, they have done the minimum amount possible,” he said. “One hopes this week is going to drive them further towards a sustainable solution.”
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Torn between the conflicting interests of its 17 constituent members, the European Central Bank is struggling to find meaningful responses. Far from managing to calm matters, it has succeeded only in further inflaming them.
Investors had been primed to expect intervention by the ECB in sovereign bond markets so as to prevent Italy and Spain going the same way as Greece, Ireland and Portugal, and that indeed is what Jean-Claude Trichet, the ECB president, appeared to sanction at his monthly press conference on Thursday.
But then it transpires that to the extent that there was intervention, it was confined to Irish and Portugese bonds, where the game is already up and bond purchases are going to make little or no difference.
After initial confusion over what precisely Mr Trichet meant in confirming resumption of the ECB's bond purchasing programme, investors responded accordingly. Up went Spanish and Italian spreads to levels which are now within a whisker of those that forced Greece, Ireland and Portugal to seek a bailout.
Matters were made worse still by the president of the European Commission, Jose Mauel Barroso, who in a letter insisted that the European bailout fund needed urgent reassessment only to be slapped down by German officials. Policymakers are at sixs and sevens, unable to agree the measures necessary to resolve the crisis. Italy and Spain are being abandoned to their fate.
Over the past fortnight, a palpable sense has grown that the global economic crisis triggered by the 2008 banking crash may only now be getting into its stride. The brinkmanship in Washington over the lifting of the US debt ceiling exposed the fragility of the world’s economic powerhouse.
Even more troubling for the markets has been the eurozone’s sovereign debt crisis. The emergency Brussels summit on July 21, which approved a further bailout for Greece and agreed new measures to prevent contagion, was supposed to have drawn a line in the sand. It did no such thing.
Yesterday, the first whiff of panic emerged from Brussels. With equity markets tumbling everywhere, Commission President José Manuel Barroso fired off a letter to all European governments, demanding urgent action to prevent the crisis spreading from the periphery to the rest of the eurozone. Mr Barroso’s language was extraordinarily blunt.
He said the markets were taking fright because of slow growth and the US debt fiasco, but “first and foremost” because of the “undisciplined communication and the complexity and incompleteness of the July 21 package”.
Such intemperate language is rare in the EU and will only increase nervousness. Mr Barroso’s frustration has clearly been fuelled by the tardy way in which national governments are ratifying the new rescue machinery (although what does he expect in August?).
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The Japanese government and central bank have intervened to weaken the yen to protect economic growth.
Japan sold yen on the markets, weakening the currency so that the dollar was worth more than 79 yen, up from about 77 yen before the move.
The Bank of Japan (BOJ) announced further monetary easing in the afternoon.
These were unilateral moves by Japan, unlike an intervention in March, which was backed by the G7 group of nations.
Analysts questioned whether the intervention would have any long-term impact.Asset buying
The BOJ said it would make more money available to financial markets by expanding a programme to buy government bonds and other securities.
The central bank will increase the money associated with that programme from 40tn yen ($504bn; £308bn) to 50tn yen.
It said it would achieve this by the end of 2012.
"The Bank deemed it necessary to further enhance monetary easing, thereby ensuring a successful transition from the recovery phase following the earthquake disaster to a sustainable growth path with price stability," the BOJ said in a statement
The central bank also decided to keep its benchmark policy rate at a range of zero to 0.1%.'One-sided moves'
The government has repeatedly warned that the strong yen threatens growth and recovery from a deadly earthquake and tsunami.
Since the last intervention, the yen had gained about 5% against the US dollar, and over the past 12 months it has risen by almost 12%.
"Intervention doesn't generally have a long-term impact on the value of the yen," said Naomi Fink of Jefferies.
"Its aim is to send a warning to speculators and to prevent markets from becoming disorderly."
The dollar was recently trading at close to 78.47 against the yen, up from 77.
Finance Minister Yoshihiko Noda confirmed the move to the media but declined to comment on the size of the intervention.
Japan's Chief Cabinet Secretary Yukio Edano said the government was stepping in at the right moment.
"Recent currency moves were one sided and could have hurt the economy, and considering this, the intervention was timely," Mr Edano told reporters.
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The cost of borrowing for the Spanish government has risen sharply at its latest debt auction.
The government successfully sold 3.3bn euros ($2.1bn, £2.9bn) worth of new bonds to investors.
However, the interest rate on 2.2bn euros worth of the debt - to be repaid in 2014 - rose to 4.813% from a rate of 4.037% at a bond sale in early June.
It also later cancelled an auction planned for 18 August, delaying its next money raising until September.
Spain has struggled to retain the confidence of lenders due to worries about its ability to pay its debts.
European Commission President Jose Manuel Barroso has written this week to all 27 members of the EU asking them to give their "full backing" to the protection of the euro currency zone.
He described developments in the bond markets surrounding Spanish and Italian sovereign debt as being "a cause of deep concern".
He also warned that, "we are no longer managing a crisis just in the euro-area periphery".
Prime Minister Jose Luis Zapatero recently delayed his summer holiday to address the mounting concerns about the government's finances.
He has also faced continuing protests against government spending cuts.
The latest bond auction also raised a further 1.1bn euros through four-year bonds that carried an interest rate of 4.98%
What went wrong in the eurozone?
However, analysts said that the Spanish government would be reassured by strong demand from investors for its bonds.
"It was certainly better than the market was fearing," said Peter Chatwell a strategist at French bank Credit Agricole.
Bonds are a form of I-owe-you issued by governments and companies seeking to borrow money.
The Spanish government has now issued 60% of its planned borrowing for the year.