Nearly five years into the global credit crunch, you get a feeling for when something has reached the point of no return, when no amount of reassurance, promises or policies will fight the tide of markets. This is not to define markets as pure ‘speculators’, rather rational individuals and entities that are removing deposits from Greek banks, reducing their exposures to all types of market risk and doing their best not to be crushed by a moving train that is Greece.
As well as reports of large-scale withdrawals from Greek banks, we have had (unconfirmed and then denied) reports that the ECB is also refusing liquidity requests from Greek banks, pushing them to the Greek central bank because of the lack of recapitalisation undertaken. We’ve seen sharp increases in forward Libor-OIS spreads, the measure of interbank liquidity risk that was so watched during the early days of the crisis. From being taboo in official circles, a Greek exit is now more openly discussed rather than dismissed outright. At the same time, after two years of fire-fighting the Greek and wider sovereign crises, there are no policy responses that can credibly stem the tide.
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We’ve had two large scale EU/IMF rescue packages, a tortuous ‘voluntary’ private sector-restructuring and vast lending form the ECB (with ever lower collateral standards applied). The more credible response now from the authorities would be measures to stem contagion elsewhere, particularly with respect to bank deposits in other eurozone countries now that permitted cross-border lending between deposit-guarantee schemes will not be workable. Contagion remains the biggest single risk, given that a Greek exit will mean that what was previously presented as irreversible and unthinkable will have become reality.
This is where efforts now need to be focused otherwise the single currency will be left horribly exposed by a Greek exit. Furthermore, all efforts to ‘save’ Greece from here on in will have been wasted and at the cost of failing to deal with the contagion issue. Policy-makers face a critical choice over coming days. Let’s hope they choose the right track.
Commentary
BoE re-opens the QE door. Never knowingly indecisive, the UK MPC re-opened the door to more QE in yesterday’s Quarterly Inflation Report. Growth prospects in the UK were again ‘unusually uncertain’ and the eurozone sovereign debt and banking crisis continues to pose a significant risk. At the ensuing press conference, Mervyn King reinforced the message, suggesting that the path to recovery was slow and uncertain. Given the extremely unsettling backdrop in Europe right now and with the UK economy officially back in recession it would have been remarkable if the MPC was not at least discussing more QE. Interestingly, although the pound gave back some of its recent gains, UK Gilts were essentially unaffected by the prospect of yet more asset purchases.
Italy back in intensive care. After a two-month respite from financial turmoil at the start of this year, Italy unfortunately is back in intensive care. The 10yr yield touched 6.0% yesterday for the first time since early March. Certainly, the very problematic situation in Greece is not helping – bond yields for all of Europe’s fiscal miscreants have climbed sharply recently. It is also the case that domestic financial conditions in Italy are deteriorating alarmingly. Recession in the country is deeper than expected – The National Institute for Statistics (ISTAT) reported on Tuesday that GDP fell by 0.8% in Q1 following a 0.7% fall in the previous quarter. The level of output in Italy is now 6% below the peak of four years ago. Moreover, the dynamics of Italy’s huge sovereign debt pose a rising danger to the banking sector which owns Italian government bonds equivalent to one third of GDP. Italian citizens are clearly concerned as deposit-flight from the country accelerates. The Italian central bank has accumulated EUR 278bn of Target2 claims with the central banks of Europe’s richer northern members. Moody’s downgraded no less than 26 Italian financial institutions earlier this week, citing growth concerns and the acceleration of non-performing loans. Although tensions are clearly rising, Prime Minister Mario Monti shows no signs of relenting on his commitment to fiscal austerity thus far. Savage spending cuts and revenue-raising measures will reduce Italy’s structural budget deficit enormously this year although, with the economy backsliding, it may not quite reach the surplus that Monti wants. Despite the best efforts of Monti to stabilise the situation, the combination of a massive debt-to-GDP ratio of more than 120%, an economy going backwards at a rapid rate of knots and evermore expensive funding costs may not be enough to prevent Italy plunging into a debt-deflation trap. Indeed, it could reasonably be argued that this horror scenario has already arrived.
Beware falling BRICs. With the dollar making all of the running over recent weeks, it has been interesting to observe just how much pressure the currencies of the BRIC economies have been under. Elsewhere, we have remarked upon the recent decline in the Chinese yuan, a function of domestic financial weakness and accelerated capital outflow. The Brazilian real has been hit hard as well, down more than 4% for the month to date while the Russian ruble has dropped 4.6%. The Indian rupee registered a record low against the dollar yesterday. Since early March, the rupee has plunged by 11%, the worst-performing currency in Asia. It is a terribly tough time in India at present – the economy is very weak (for instance, industrial production fell by 3.5% in the year to March), while the combination of a much weaker exchange rate and high energy prices means that inflation remains very high. Standard and Poor’s lowered the outlook on India’s sovereign debt rating to BBB- late last month. Indian stocks fell to a four-month low overnight. Right now, the prognosis for India is looking decidedly bumpy.
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