The situation of the European Monetary Union may already be close to critical: the economic downturn is entangling the southern states of the region, and German investors are cutting off a vital source of foreign financing, Swiss bank UBS uncompromisingly writes in its report. “The next two years are likely to be the most serious test of the strength of the single currency to date,” says European bank strategist Meyrick Chapman. “We expect the test to end without loss. Too much political and economic capital has been invested to destroy this project. But the correction is likely to be tough,” he says.
UBS has warned of a “freeze on financing” for countries with very large current account deficits, such as Spain, Portugal, and Greece, which have to rely on a strong inflow of foreign capital to fill this gap. Spain has accumulated the largest liabilities with other countries, with the result that external debt is now $ 362 billion (£ 180 billion), or 26% of GDP. Italy accumulated $ 275 billion, Greece – $ 129 billion, Ireland – $ 123 billion, and Portugal – $ 98 billion.
Most of the funding came from German banks and pension funds. They showed a brutal appetite for the so-called “saddles” (secured bonds) and other forms of debt of Spain, which grew at a frantic rate from 2005 to 2007. Profitability was higher than unattractive domestic offers. Since then, the Germans broke the guillotine. “After the market was destabilized in July 2007, German buyers almost completely disappeared from the Spanish market,” says UBS. The valve was shut off, and Spanish borrowers simply languished from a lack of funds. Many ran for temporary financial assistance to the European Central Bank, using unsold mortgage bonds as collateral for a loan through the Frankfurt window. The issue takes on a political character. “There may be awkward questions inside the ECB Council,” the bank added.
According to EU rules, funding should be “limited and short-term.” The Spanish Banking Association insists that national lenders continue to be healthy and stand on a solid financial foundation. The investor’s escape from the region is already evident in the galloping yield spread between 10-year German government bonds and the equivalent bonds of the countries of the Latin bloc. After spreading steadily in the area of the mark of 20 over the past few years, last summer they began to expand, and this week they literally left the coast. Spreads for bonds of Italy and Greece – two countries whose government debt exceeded 100% of GDP – reached 70 basis points. “This is certainly a signal that financial policies must be approached very carefully,” said ECB President Jean-Claude Trichet.
Some hedge funds and banks are betting on further divergence and open short positions on Club Med debts (which include Italy, France, Spain, Portugal, Greece, as well as Ireland, Belgium and Slovenia) against long German government bonds. Goldman Sachs, BNP Paribas and Deutsche Bank – all these banks in the last few months have advised their clients to open such positions. Countries with obligations that are most susceptible to such attacks differ from each other. Spain has a current account deficit, which accounts for approximately 10% of GDP, and a deflating bubble in the real estate market, but is in a good financial position. The situation with the trade balance of Italy is fixable, but the country is heading into recession.
The common feature of all southern countries is a hopeless loss of competitiveness compared with Germany year after year for a whole decade. UBS is still unclear how Europe intends to deal with the inevitable crisis. EU rules prohibit the ECB from supplying liquidity to banks that are “potentially” bankrupt. An IMF study says: “larger countries will ultimately take on a disproportionate share of the total burden.” Hmm, the Germans are unlikely to like this prospect.