A couple of weeks ago European finance ministers attended an informal meeting in Copenhagen to sign off on one of the final components of the plan to deal with the debt crisis once and for all. In return for funds from their richer EU partners in the form of bailouts and a firewall to deal with future problems, peripheral euro zone members were to put their house in order, imposing austerity measures to help cut, or at least slow the pace of incurring new debt.
Aided by nearly a trillion dollars of assistance from the ECB’s Long-Term Refinancing Operation (LTRO) which ended fears of a fully-fledged banking crisis in late 2011, policy makers met in Denmark hoping the worst was now behind them.
But having agreed upon extra funding for the IMF’s own rescue fund over the weekend, policy makers will unfortunately not be able to look forward to a calmer summer and two weeks on the beach.
The reason thousands of politicians and bureaucrats will not be able to hit the beach is an EU member that could do with as many people as possible spending the summer on its beaches: Spain. The cost of borrowing over 10 years for the Spanish government is now 6 percent after heavy selling of Spanish debt by bond traders who had just a few months ago been buying heavily using ECB money. The IBEX 35 in Madrid has seen huge volatility as investors question the sustainability of Spanish housing prices and the debt that banks hold against it.
“It is becoming increasingly likely that some kind of support program for Spain will be needed” said Carl Weinberg, the chief economist at High Frequency Economics in a research note on Monday. “The yield on Spanish 10-year debt is approaching borrowing rates that are destabilizing and un-economic.”
Spanish and European officials will not agree with Weinberg, particularly in public, but whether they like it or not ,the bond vigilantes are back and ready to test their resolve. Those betting against the Spanish bond market are not just betting against Spain and its imbalances, they are betting against German Chancellor Angela Merkel and ECB President Mario Draghi’s resolve to protect the European project.
Up until now the support of Angela Merkel and Mario Draghi for countries finding themselves in trouble has been dependent on them implementing austerity measures and halting runaway government borrowing. So far those having to accept big cuts have played along, with Greece, Ireland and Portugal imposing massive cuts in return for bailout cash, and others have also gone along, to avoid the fate of Greece in particular.
Doubting the path set by Germany and the ECB has been frowned upon and in the case of former Italian Prime Minister Silvio Berlusconi led to him losing power. But opposition to austerity and plan A is beginning to grow in more prosperous places than Athens and Lisbon. In France, one of the architects of the plan to resolve the debt crisis, Nicolas Sarkozy, risks losing power to socialist candidate Francois Hollande.
Hollande won this weekend’s first round vote promising to focus on growth and is now favorite to win the French presidency despite over a third of all voters backing either the far right or extreme left. Whether or not Hollande will back Angela Merkel’s thinking on the debt crisis could define the EU response in the second half of 2012, but the optimists say his election would not have to be a negative.
“Let me point out that sometimes changes open up new opportunities for reforms - the “Nixon goes to China” paradox. For example, France needs labor market reforms and I suspect that a socialist president would have a better chance of getting that done than a center-right president would, but we will see,” said Erik Nielson, the chief economist at Unicredit in a research note on Monday.
To the north of Paris in the Netherlands, talks over slashing government debt collapsed over the weekend after an anti-euro right wing ally of the governing coalition walked out demanding elections as “soon as possible”
“It is very regrettable that this government cannot finish its job,” said Frans van Houten, the CEO of Philips in a CNBC interview following the release of forecast-beating numbers which had little to do with the health of the Dutch economy.
Alistair Newton, a political analyst at Nomura following the news from the Netherlands said: “Although failure by the Netherlands alone to ratify would not in theory spell the compact’s demise – only 12 out of 17 euro zone members need to ratify for it to come into force – it would at best significantly damage the compact’s credibility and at worst encourage other members to follow suit.”
With opposition to austerity measures rising and the debt crisis moving to Spain, the current plan A is under threat and this could spell trouble for euro zone resolve, according to Newton.
“With the compact under threat, in Germany Chancellor Angela Merkel’s domestic challenges surrounding the euro zone crisis are likely to become still more complicated. She may find herself coming under increasing pressure at home to draw a line under further support for the struggling peripherals should they need it, potentially opening the door to a disorderly default on debt repayments and related euro zone exit,” said Newton.
The problem is that governments across the euro zone are finding it very difficult to live up to commitments on austerity and stay elected. Carl Weinberg said Spanish Prime Minister Mariano Rajoy and his government should restructure the country's debt, swapping paper due in the next 3 years for 30-year debt so it would have time to pay off. Weinberg thinks this solution will not be taken up, but questions why Spain will not seek bailout funds when it is going to have to take the austerity measures anyway.
Maybe the best way to stay in power is to get the best deal possible when defaulting, sorry restructuring, your countries obligations to bond holders.
“Spain and perhaps Italy, will end up borrowing more money than it should from EMU governments and taxpayers. Euroland policy makers have yet to learn that lending more money to over borrowed nations is mistake” said Weinberg.
As we wait to see if support for "plan austerity" will collapse and look for clues about how this would impact the policy response if it does, investors might need to pay close attention to those proposing ways to kick-start growth, rather than those demanding everyone push on with plan A.