The ECB gives Portugal a helping hand with its return to the markets

Portugal this morning followed the lead set by Ireland and Greece and issued new debt for the first time since its bailout in 2011.

Portugal managed to sell €750m of 10 year bonds at an average borrowing cost of 3.58% and with demand totalling €2.6bn (3.47 times the desired amount). This is a successful return, albeit not quite as large as Greece’s or Ireland’s issuance.

Again, many people will be asking why a country with uncertain funding conditions over the coming years saw such solid demand for its debt, even before it exited its bailout. As with Greece, we would say many of the factors are more to do with the state of the broader market than specific to Portugal:

• The issue remains small with a decent yield – there will always be demand for this kind of risk and return.
• This is particularly true in the current market where interest rates are at record lows and there is a dearth of safe assets which still yield a decent profit.
• The ECB and the eurozone have shown their commitment to keeping the eurozone together and have shown a renewed aversion to private sector write downs on sovereign debt. This combination provides insurance to investors that, even if the Portuguese economy struggles, the rest of the eurozone will ensure that it continues to pay its debts.
• Of course, all that said, the reforms which Portugal have instituted and which have helped boost exports will play some role in encouraging investors.

One specific point to note though is that, on top of the general support given by the ECB mentioned above, it also gave Portugal a more direct helping hand.

Die Welt reported on this issue today, terming it a “trick”. In reality, the ECB has altered its collateral rules so that, when Portugal exits its bailout, its government bonds will still be eligible as collateral for its lending operations. The change was snuck through as part of a package of changes in ECB/2014/10 ‘amending guidelines for ECB/2011/10’ last month.

The ECB’s line seems to be that this was simply a move to bring all the ratings from different agencies into line for collateral, so they correspond to the correct level in the other agencies. This is a fair point, but the timing seems more than coincidental, especially since these rules have been in place since 2011.

The thinking is that, without this change, demand for Portuguese debt would have been limited since it couldn’t be used to gain liquidity from the ECB (we explained here why ratings are still important for just this reason). As such, the ECB looks to have given Portugal a helping hand.

We have written before about concerns over the ECB’s independence during the crisis, particularly in relation to adjusting its technical rules to aid struggling countries. This seems pretty close to falling into that category and highlights that, even though the crisis has eased somewhat, the ECB still finds itself treading some difficult boundaries with regards to its independence.

All that said, this remains a positive, if small, first step for Portugal. Questions remain about whether it will be able to fully fund itself without a credit line from the EU/IMF and whether export growth will be enough to offset the collapse in domestic demand and investment.

What’s wrong with Finland? Part 2

Since our last post on this issue things seem to have only got worse for Finland.

The European Commission’s latest economic forecast (see table below, click to enlarge) made pretty dire reading with Finland expected to be one of the worst performers in terms of economic growth over the next two years.

Furthermore, it seems that the credit rating agency S&P has finally caught up with our analysis of Finland, putting its AAA rating on negative outlook, suggesting that it may lose it in the next couple of years. Similar to our concerns about the rebalancing of the Finnish economy, the demographic problems and a stubborn lack of competitiveness, S&P noted:

“Finland’s persistent subpar growth rate reflects deep structural demographic and economic imbalances that hamper the government’s efforts to achieve fiscal consolidation. We consider that there are downside risks to growth and policy implementation.”

“We believe that the economy remains vulnerable to any slowdown of economic activity in the euro area or among other major trading partners, such as Russia.”

As the second part of the quote suggests, the situation in Ukraine and the potential sanctions on Russia are also likely to worsen the outlook for Finland.

The graphs above (data from Bank of Finland) highlight that Russia accounts for a decent chunk of Finnish trade and given the dwindling sources of growth any hit to this could certainly hamper the rebalancing of the economy and the reform/recovery process.

Furthermore, as we have flagged up before, Finland is one of the many countries heavily reliant on Russia for gas and energy more generally. With Putin’s threat to cut off gas to Ukraine the situation has potentially escalated another step, at least in economic terms, Finland is one (of the many countries, including Russia) which is on the front line.

Once again, all this is not to say that Finland is an economic basket case, far from it, but that even the healthy economies in Europe are undergoing some serious overhauls and reforms, further complicating the crisis response and, now, dealing with issues such as the Ukraine-Russia crisis.

What’s wrong with Finland?

That seems a strange question to ask. The country is a paid-up member of the eurozone core and is one of the few countries in the world to have a triple A credit rating from all three top agencies (S&P, Moody's & Fitch) and a stable outlook from all.

However, as the chart to the left shows (taken from the most recent Finnish Central Bank Macroeconomic bulletin) and today’s GDP data confirm (the Finnish economy contracted by 0.8% in Q4 2013) suggests all might not be well.

GDP growth has stagnated and is now teetering on the edge of slipping into its third recession in six years. But what has been causing this? The chart below on the right provides some insight.

The first point to note is the collapse in the electrical and electronics industry. This has been largely down to the struggles of Nokia. Formerly a dominant player in the telecoms market the firm has failed to adapt to the changing nature of the market, in particular the smart phone phenomenon, and has seen its market share, profits and share value eroded. The sector has also suffered knock on effects of the reduced global demand in the wake of the financial crisis, the threat of low cost emerging markets and the struggling domestic demand due to falling confidence.

Similarly the large metals industry has also been hit by the global downturn and has struggled with price competitiveness. In particular the ship building industry would have been doubly hit by the struggles in global trade and is yet to truly recover.

It was previously said that Finland lived off its forests. This is no longer true, or at least it is no longer able to fully. The forest industry and the related wood, textiles and paper industry have struggled with changing technologies. Demand for paper and related products has fallen substantially as digital replacements grow and environmental concerns take hold. Again cheap emerging market products may also threaten in this area.

The combination of all this has been falling employment and an accompanied fall in domestic demand, keeping downward pressure on the economy. At the same time Finland is also beginning to run into the same demographic problem facing much of the developed world – the decline of the working age population and the increase in the number of dependants.

It’s clear that Finland remains a very strong and healthy economy. However, it is clearly undergoing some serious structural changes and may continue to post low growth figures for some time to come. Fortunately, public debt remains low at around 59% of GDP, while the deficit continues to be under control at 2.4% of GDP, and unemployment remains at just 8.1% despite recent increases. This should give the country plenty of space to conduct the structural changes needed.

That said, the case of Finland provides further evidence (as we have pointed out for Germany) that the peripheral eurozone countries aren’t the only ones undergoing significant changes.

EU hit with downgrade

While the spate of EU downgrades has slowed to a relative drip feed this year, it turns out there was at least one left in the locker – the EU, which Standard and Poor’s (S&P) this morning cut from AAA to AA+.

Many may ask, does the EU even have its own credit rating? And if so why? The answer is, of course it does, although why is a bit more ambiguous. It relates mostly to the rating of the EU budget and any bodies which borrow with EU guarantees. This includes the European Financial Stability Mechanism, the smaller €60bn bailout fund which is backed by the EU budget.

The move is largely symbolic but the reasoning behind it is interesting if a bit strange in places:

• The first couple of points are obvious: the on-going financial and political instability in some states has led to the downgrade. This is par for the course in terms of ratings.
• It’s also obvious that the EU rating would be reflective of the ratings of its largest members, some of which have seen downgrades over the past year.
• However, it then gets a bit odd. S&P cites the EU budget negotiations, which were admittedly tricky and divisive, as an example of declining support for the EU. Firstly, the budget negotiations are always difficult but were eventually concluded and were pretty much wrapped up early this year. It’s also a bit strange given that the budget cannot run a deficit and countries are obliged to contribute – it’s not clear exactly how this relates to a credit rating issue.
• The final point S&P raised was the issue of ‘Brexit’ and how the UK referendum could create uncertainty. Again this is some time away so the timing of the decision seems strange. Nevertheless, it does drive home an interesting point, in that S&P believe the EU would be less creditworthy without the UK. Something for members to ponder as the push for reform begins to get underway properly.

In any case, the main impact is likely to be symbolic. S&P have choice timing delivering the news on the same day when there was much backslapping and congratulations over reaching a deal on the banking union.

Some ratings still matter in the eurozone

A general view seems to have come to pass (and not without good reason), that ratings actions in the eurozone have much less significance these days. This is mostly because the ratings agencies tend to 'lag' the market – meaning that a downgrade only comes once everyone already knows a specific country is struggling. The main outcome is usually a bad-tempered back-and-forth between governments and the agency in question, and then another call for EU regulation of rating agencies.

However, sometimes a rating change comes along that could have some material impact. In this case, it comes from a lesser known agency – Dominion Bond Rating Service (DBRS). In an interview with Spanish daily Expansión this morning, their Head of Sovereign ratings Fergus McCormick warned that Spain’s rating remains under pressure and that it is too early to tell if the crisis has bottomed out (as many in the Spanish government have suggested might be the case). DBRS' latest report on Spain, from March this year, also struck a more cautious tone.

This is interesting because, as Reuters pointed out in July, DBRS is the last rating agency to give Spain (and Italy for that matter) an A rating.

As the article also explained, this could cause problems for Spanish banks for the following reasons:

• They hold a large amount of Spanish government bonds as collateral for their borrowing from the ECB;
• Under ECB rules, the ECB judges collateral based on the highest single rating from four eligible agencies (S&P, Moody’s, Fitch and DBRS);
• The value of these bonds is subject to a haircut – for example a highly rated 10yr+ government bond would be subject to a 5% haircut, meaning a bank could borrow up to 95% of the bond's value under the ECB’s liquidity operations (see here for the full ECB collateral haircuts);
• However, once the rating falls, the haircut to such a bond jumps to 13%. This means banks using such bonds as collateral would have to reduce the amount they borrow from the ECB or produce more collateral to cover their current level of lending.

As of July 2013, Spanish banks were borrowing a combined total of €252 billion from the ECB, although this is well down from a peak of €411 billion in August 2012. This suggests that Spanish banks should have plenty of surplus collateral to fill any hole that opens - the muted market reaction so far also suggests as much. That said, the banks are currently de-leveraging significantly (selling off assets to reduce their balance sheets) and running a tight line in terms of balancing the books and trying to keep costs as low as possible. A hit such as the one described above is likely to be far from welcome.

Friday the thirteenth in the eurozone…

Over on the Telegraph blog, we look at today's euro developments:

It all looked so good in euroland after a market rally and successful Italian and Spanish bond auctions this week. However, on Friday the eurozone crisis again took a turn for the worse. Standard & Poor's – the increasingly unpopular credit rating agency – is set to downgrade France and Austria from their AAA ratings. At the same time talks broke down over what losses banks and other bondholders will be forced to accept when Greece writes down its massive debt, injecting another huge dose of uncertainty into the euro mix.

Euro policy geeks are already engaged in fierce debate about which of these two events constitute the worst news for the eurozone. Let’s have a look:

Downgrades: Friday the thirteenth jinx aside, this downgrade could be spotted a mile away with S&P putting the whole eurozone on negative watch before Christmas. Other eurozone downgrades are also taking place, notably of Italy, but the loss of AAA ratings are undoubtedly the most critical. In addition to the symbolism of having one of the EU’s big three economies downgraded, the eurozone’s €440bn temporary bailout fund (the EFSF) – aimed at backstopping fragile euro states – could be soon to follow. The EFSF needs its current AAA rating to continue to dish out cheap loans to Greece, Portugal and Ireland (and any other country that might need help). But as France is a major contributor to the EFSF, a downgrade for the country could result in a corresponding slash to the rating of the EFSF.

The effect would be higher borrowing costs for the struggling countries that tap the fund, reducing effectiveness of the ESFS as a backstop measure. In addition, an EFSF downgrade will make the fund – and the eurozone – even more reliant on German taxpayers. This would further expose the German economy to potentially bad eurozone debt and, at worst, even threaten the country's own credit rating.

It also raises even more questions about an EU plan, currently being negotiated, to increase the lending capacity of the EFSF through a complicated leveraging and insurance scheme (for details, see here). You simply cannot create money out of nothing – and even more so when one of your key players has just suffered injury.

So expect short term market jitters. But so far, we’re only looking at one credit rating agency, with the other two holding their fire – which is probably why the news coming out of Athens is more significant.

Greece: The negotiations over losses for investors in a voluntary restructuring of Greek debt are starting to look like a bad horror movie. For all the grand talk from EU leaders and officials, bondholders (especially smaller firms such as hedge funds) still have a massive incentive not to participate in the voluntary restructuring – either Greece pays back the money they owe them or there is a default, in which case their insurance on Greek debt (known as credit default swaps) are paid out and they recoup their losses at least.

The crux is that Germany and the IMF in particular have made a write down of Greek debt a precondition for paying out the next trance of bailout money, which Athens needs by March 20 to pay off €14 bn in debt due. If neither Greece, the bondholders nor Germany/IMF blink, we may be looking at a forced Greek restructuring (where Greece legally enforces losses on bondholders) or even a full default and, at worst, a eurozone exit. But there’s still plenty of negotiating time before March.

What’s clear is that both the downgrades and the break-down in the Greek restructuring talks could change the face of the eurozone crisis. Though the downgrades seem more dramatic now, the Greek problem could soon begin to hit home. An enforced write-down or uncontrolled default both essentially amount to the same thing in the eyes of the markets and investors will begin to have doubts about the future of other eurozone countries – if a default can happen in Greece, why not in other insolvent eurozone states?

Tags: bail-out, Credit Default Swaps, credit rating, default, eurozone, France,Germany, greece, Sarkozy, sovereign debt crisis

FrAAAnce misses the point...

For all those who think that French President Nicolas Sarkozy will be sitting in the Élysée plotting some form of retaliation against Cameron, it has quickly become clear that he has much bigger things to worry about.

Rumours have once again been flying around that France’s triple-A rating is under threat and could be facing an imminent downgrade. These have become all the more serious by the numerous French government ministers that have publicly played down the gravity of any downgrade.

On Monday Sarkozy said that a downgrade would be “one more difficulty, but not insurmountable.” On Tuesday Valerie Percresse, French Budget Minister, made similar remarks saying, "The fundamentals of the [French] economy are good, and investors don't doubt France will pay back its debts," thereby playing down the impact of any downgrade. Finally, yesterday French Foreign Minister Alain Juppe said, “[A downgrade] wouldn't be good news, but it wouldn't be a cataclysm either. The United States lost their triple-A and still manage to borrow on the markets in good conditions.”

This public onslaught by the government on the cost of France losing its triple-A rating is widely being seen as a way of softening up the public and the markets for what’s coming. Ultimately, the impact of a downgrade on France will depend on numerous factors, not least: whether other countries are also downgraded, whether it is a one or two notch downgrade and the level of upcoming public and private financing which France faces immediately after the decision.

Our concern though is not about the impact on France. In fact the French government seem to be missing the bigger picture – the impact it will have on the eurozone bailout funds. The eurozone is already running short on money, at least in terms of providing a financial firewall to stop the crisis. As we noted in our ‘No Way Out' report a downgrade would not be good:

Since the EFSF’s Triple-A rating relies on Triple-A countries, a French downgrade would also mean a downgrade for the EFSF itself. For such a downgrade to be avoided, the remaining Triple-A countries would need to substantially increase their share of the guarantees, transferring even more of the burden on the already reluctant German taxpayer – while also threatening Germany’s own rating. In all likelihood, under the increased EFSF scenario, a downgrade of France would trigger a downward spiral of ratings cuts due to the extra EFSF liabilities which would make the entire fund completely unworkable.

So a French downgrade would be bad for the EFSF, the eurozone’s temporary bailout fund, while numerous downgrades could spell the end of its ability to borrow, and therefore lend, at low cost. It could also spell trouble for the ESM, the eurozone’s permanent bailout fund, which, despite some paid in capital, also largely relies on guarantees from its members.

In any case, the French government may be softening up its population for a downgrade, but who’s going to soften up markets for the realisation that the eurozone bailout funds could be rendered close to useless (more useless?)….

Update 15/12/11 12:20pm:

Christian Noyer, Governor of the Bank of France, today launched an attack on the rating agencies (and the UK), suggesting that they are not basing their decisions on economic fundamentals and if they were the UK would/should be downgraded before France.

Noyer raises some valid concerns about the level of the UK's debt, deficit, inflation and the dwindling credit availability - but he, like his colleagues mentioned above, misses the key point. The UK has full control over its own monetary policy and can balance it with its fiscal approach in any way desired. France however faces: a central bank whose thinking runs completely contrary to the government's desires, an overvalued currency, increasing fiscal constraints due to its exposure to the eurozone crisis and a looming election (along with potential political divisions over the eurozone crisis). All in all, the UK may economically be in just as bad a position as France, but the UK has the tools to deal with its problems, the French government is, on the contrary, massively constrained.

Summit side note: Beginning of the end for CDS?

An interesting side note to the second Greek bailout deal is that it may in fact have killed off the credit default swaps (CDS) market, or at least kick-started its demise. The reason for this is simple: the deal undermines confidence in the belief that CDS can work as a form of insurance against default. (A quick recap: a CDS on sovereign debt is essentially a form of insurance, which the purchaser pays into every so often and which pays out if the country defaults on its debt. As such it is used as a hedge against exposure to sovereign debt as well as against lending in unstable/risky economies.)

Fitch and Moody’s have already declared that they consider the private sector involvement in the second Greek bailout to be a default. This is because bondholders will be taking part in a bond swap or rollover which will result in them receiving less money than promised under their original bond. Simple enough and probably the correct decision.

So why aren’t CDS paying out? A credit event or default which would trigger CDS is determined by the International Swaps and Derivatives Association (ISDA) which has announced that it does not judge Greece to be in default. This is because the bond swaps or rollovers are completely voluntary. If CDS were triggered you could get a situation where people who didn’t take part in the swap or rollover are still getting paid out on their CDS and so are reaping their full rewards of both the Greek bond they’re holding and the insurance on it – a perverse situation, no? So, clearly, this looks to be the correct decision as well.

So, since you have a situation where the increasingly expensive insurance on Greek sovereign debt essentially becomes useless, the whole market for CDS has become undermined, possibly irreversibly so. We’ll gloss over whether this was intentional or not for now (undoubtedly there are plenty of EU officials who would like to punish the CDS market for what they see as detrimental speculation in the financial and eurozone crisis, as we’ve pointed out with our commentaries on the new short selling regulation). But it goes to show that the complexities of the eurozone bailouts can lead to significant and potentially harmful side-effects.

Let's not kid ourselves, CDSs can be used as a speculative tool but also play an important role in market liquidity nowadays. Reducing the use of CDS makes it harder to hedge against risk; this could make investors less keen to purchase the sovereign debt of struggling eurozone countries (such as Spain and Italy) and could therefore filter through to higher borrowing costs for many eurozone economies (due to higher risk premium). It could also make it harder for the private sector in these economies to get loans and funding as well, since CDS is often used to insure against the risk from these types of loans. So, in sum, we could see higher borrowing costs and lower economic growth as an impact of a smaller CDS market, clearly not a desirable effect given the current crisis.

Although, we’re sure there will be a few EU officials with a wry smile on their face at the potential demise of the CDS market, intentional or not, it could yet come back to haunt them.

Everybody's lining up to comment on the euro now...

Just thought we’d highlight some interesting comments on various aspects of the eurozone crisis, given the sheer volume of pieces out there.

Leading economist Kenneth Rogoff talking about Greece on BBC Hardtalk:

“I don't think there is any question that if you look at it narrowly from Greece's point of view, it would be better to default now, clean it up and move on. Yes, it is painful to default, but countries grow afterwards and many countries have done it and done very well. The problem here is that Europe can't handle it so easily because Portugal is weak, Ireland is weak, the banking system is weak. And in essence what's happening is that Europe is bribing Greece not to default. They are giving them lots of money. Greeks aren't paying now, they are getting new money”.

Ambrose Evans-Pritchard (back with a vengeance) writing in the Telegraph on the EU and credit rating agencies:

“The EU authorities are attempting to muzzle free opinion, first by threatening Fitch, Moody’s, and S&P with vague retribution, and then by drafting restrictive laws to prevent them from publishing unwelcome messages.”

“Now, if the EU institutions wish to avoid being held hostage by the robber agencies they should stop using the ratings as a basis for lending collateral at the ECB. They should create their own more rigorous method of assessing credit-worthiness, ignore the agencies altogether, and make their case directly to global investors…What the EU should not do is try to muzzle free opinion, or free speech. We are on a slippery slope.”

Nick Malkoutzis in Greek paper Kathimerini highlights the coming pain for Greece under the second bailout agreement:

“Like a Hollywood sequel which follows a dire original, Memorandum II is likely to make us want to look away in horror.”

“But as we move from Memorandum I to its potentially scarier successor, it still doesn’t appear to have sunk in either at home or in Brussels, Frankfurt and Washington, where the decision makers of the European Commission, European Central Bank and the International Monetary Fund reside, that all the slashing of public expenditure and hiking of taxes is not going to solve Greece’s problems."

Just snippets of some good pieces, we recommend reading/listening to them all in their entirety.

Permanent euro bail-out fund failing before starting?

Standard & Poor’s yesterday downgraded both Greek and Portuguese debt by one notch and kept them on negative outlooks. That hints at further downgrades in the near future, although given the extent of the problems in both countries that could be as soon as next week.

More interesting to us, is the reasoning behind the downgrade. S&P directly puts its decision down to the agreement which was reached on the permanent bailout fund (ESM) at last week’s EU summit. In particular, the fact that, as expected, ESM debt will be senior to all private debt and taking loans from the ESM may be conditional on restructuring debt. S&P suggests this could be “detrimental to commercial creditors”.

Investors feared ESM uncertainty, but if there’s one thing markets hate more than uncertainty, it’s having their fears crystallised by government policy. The ESM undoubtedly makes peripheral government bonds more risky to hold and was always going to be met with a downgrade and higher borrowing costs. The real questions remain: Why did EU leaders decide to announce this two years in advance, thereby massively prolonging and increasing the pain of peripheral economies? And at the same time why did they put off dealing with the temporary bail-out fund, the EFSF?

There's still no agreement on how to top up the EFSF, which in turn makes investors doubt the EU's capability to deal with future bail-outs. Sorting out the EFSF might have helped limit the fallout from the ESM decisions; in any case it makes no sense to delay the more pressing of the two issues. Flagging up the fact that debt restructuring may be possible down the line somehow manages to simultaneously ignore the fact that it should be done sooner while also increasing the need for it.

Eurozone countries continue to complain about rating agencies' actions – which are admittedly far from perfect – but maybe they should stop throwing fuel on the fire.

While the principle behind it is very much welcome - putting the burden on taxpayers rather than investors - due to poor sequencing and timing, the ESM has managed to fail before it even came close to starting. That’s impressive even for an EU policy.