Sunday, May 02, 2010

Barbarians at the Gate

EUR/USD 1.3315 Hi 1.3343 Low 1.3233
USD/JPY 93.91 Hi 94.57 Low 93.86
AUD/USD 0.9249 Hi 0.9323 Low 0.9245
EUR/JPY 125.07 Hi 125.95Low 124.30

First the facts: every single major OECD Government is running a deficit this year. Big ones. All those Governments must also return to the market in 2010 to roll over maturing debt. As for paying back debt, two words: ha ha. To even pay off interest on existing debt they would need to run a surplus equivalent to the interest bill. No-one is doing that. Government deficits are thus a combination of interest payments and all the new and exciting spending programmes they came up with recently. Government funding programmes are much bigger than that. Government funding programmes for 2010 include any debt maturing in 2010 and the deficit.

For the United States the 2010 funding programme amounts to 1.7 trillion USDs and next week the Fed will complete its U.S. bond buying programme. So the U.S. Government will no longer be able to count on buying from the U.S. Federal Reserve. It's crunch time. AGAIN.

So we have all these Governments borrowing. Big deal. It was ever thus. The crucial problem is that some countries have domestic savings to call on. Some do not. But everybody wants the money. So what to do? Well, when you haven't got a large domestic savings pool of your own you need to gain access to other people's money. Now the U.S. has been successful at that, to a point. The reserve currency status of the USD and the willingness of Asian countries to accumulate reserves in USDs kept the U.S. flush with funds, the USD supported and the U.S. economy on a roll through the Clinton and Bush Administrations. The rush in Asia to build foreign exchange reserves following the 1990s Asian crisis helped, a lot. But that rush is over and the U.S. still has this massive funding requirement. So what to do? Where else would savings potentially be available?

Well there aren't a lot of choices. It's not Latin America and it's not Africa. So that leaves Europe, specifically the Eurozone.

Germany runs one of the largest current account surpluses on the planet and there is only one way to do that: you have to export your savings. That's Balance of Payments 101, look it up.

Germans, for reasons best known to themselves, don't seem to be able to find investment opportunities for their savings at home. Why? I have no idea. If the money stayed at home maybe they they could use it to get the local property market off the floor or even discover the joys of home ownership. But no, Germans, perhaps as a result of their catastrophic currency management during the Weimer Republic, prefer to send their savings elsewhere. In the 1980s they were big on AUD-denominated bonds: high yields, nice country. That worked out well. Not. The AUD dropped, the Germans lost their shirts. Earlier this century they thought U.S. sub-prime looked good. Nice rating, safe country. Not. And then there was Europe, a flood of foreign money drove Greek Government yields to within a whisker of yields in Germany. Another good idea. Not.

The big focus of attention then is: Germany the cash cow. The unfortunate thing for countries without a large and reliable savings pool is this money has largely been directed towards other Eurozone countries. Spain and Greece saw money pouring in following the introduction of the Euro and this pushed their current account into deficit. Big time. Balance of Payments 101: if you import other people's money your current account moves into deficit. Just ask the Australians they know all about it.

And so there we have it: the Eurozone current account is pretty much in balance but within the Eurozone lots of German money is moving across borders, creating booms and busts and a certain amount of havoc in its wake. And this footloose pool of German savings is very exciting. The question is: how do non-Eurozone countries get their hands on it? NOW. When they really, really need it?

Well a Eurozone crisis might help.

And so to the crisis. In this kind of deficit/debt environment all you need to bankrupt a Government is to convince investors to stop turning up for Government bond auctions. If investors stop turning up any OECD Government at all (France, Germany, the U.S., the U.K., Japan....) would be unable to refund maturing debt and would be forced to default. So you need to get investors to stay away. You need to create a market panic. Which means you need control of the media and, crucially, the Ratings Agencies. If you have a clueless or complicit politician on hand it doesn't hurt either.

First pick your market: make it small and exposed to foreign investors. Foreign investors, especially institutional investors, are a lot easier to scare than say Japanese or Italian housewives. Institutional investors don't know, don't care and just want to make sure the pay checks keep coming in. If there's a panic, they're in it. For sure.

Get the clueless politician to make a few irresponsible statements about Government debt. Get the Ratings Agencies on it and send in the media attack dogs. Hopefully you get a market panic. And they did all that. Only every single Greek Government bond auction held in 2010 has been over-subscribed by a huge margin. Which is unfortunate for the cause. As long as investors keep turning up then a Government can keep funding itself. Yields might be high, they were before Greece joined the Euro and in normal market conditions higher yields would reflect two things: high Government debt levels and a reliance on foreign savings. Which is why Japanese Government bonds yields are so low. The Japanese Government has accumulated the equivalent of circa 180% of GDP in debt. Yields on 10 year Japanese Government debt currently stands at just 1.29%. Why? Because Japan has plenty enough domestic savings and doesn't need foreign investors. When Moody's downgraded Japanese debt to levels below Botswana in 2002 it had precisely no longer term impact. Nice try.

But back to Greece. All the Anglo-Saxon press expressed surprise at just how well Government bond auctions went in 2010. It was inconvenient. But they kept harping on how yields had risen. Back of the envelope calculations were bandied about. Everyone agreed that the situation was not sustainable. But it wasn't enough. So the clueless politician was called upon to complain about the rising cost of financing Government debt. I guess he wants yields to go back to near German levels. Which is a big ask when you have a large debt and rely on foreign capital to fund it. Still. No-one questioned this slightly loopy idea. It was accepted as the right idea, all the Greeks needed to do was tighten fiscal policy. Hard. That way in exchange for a catastrophic recession they could maybe bring down Government bond yields. A strange trade off: massively tighter fiscal policy in exchange for slightly lower domestic interest rates. The economy gets killed so you can pretend to be Germany. Right, I forgot this is the Euro area now so we are all pretending to be Germany.

The Anglo-Saxon press kicked into gear and the Ratings Agencies started to speed up downgradings. On the back of nothing in particular, except maybe the knowledge that the FED will complete its U.S. bond buying programme next week, there was an unseemly rush to downgrade Spain, Greece and Portugal. European Ministers were aghast. Slightly flat-footed but aghast. Noises about setting up their own agencies have been made.

The Spanish Prime Minister launched an investigation. The Spanish National Intelligence Center (CNI) is investigating "whether investors' attacks and the aggressiveness of some Anglo-Saxon media are driven by market forces and challenges facing the Spanish economy, or whether there is something more behind this campaign." And he was ridiculed of course. In the Anglo-Saxon press.

And so here we are: showdown. Can the Ratings Agencies deliver even more suitably targetted downgradings? Can the hysteria in the Anglo-Saxon press ratchet up a notch? Can investors be driven into the arms of the U.S. Treasury which will welcome them with open arms and offer a safe haven from all those nasty, big-spending loafers who occupy the Garlic Belt? Time will tell.

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