Madrid is burning these days, one hundred thousand people were demonstrating on Thursday against the latest budget cuts approved by the government of Prime Minister Mariano Rajoy. It happened in Greece before as well as in Portugal and Italy and now it's Spain's turn. The streets have been taken by protesters, cops, rubber bullets, plastic balls and some fights. Is the market ready to see in Spain what happened in Greece? The next six months will let us know.
The Eurozone is not fixed and it has a lot of challenges for the coming months: Spain to go for a full bailout, Italy to face the advent of Silvio Berlusconi for his 7th term, new failures in Greece, fiscal union or just a monetary union or the problems to remain together as a bloc.
What is the market trading? Distortions, fundamentals, rumours... Will the Euro fall below the 1.20 mark in the coming months? A lot of questions for leaders who couldn't reach significant advances in the first half of the year. Anyway, no problem, let summit again...
Spain as the main character of its reality show
Finally they reached it! After years spending bunches of money in projects like the Castellón airport where the only airplane which is there is a statue, or artificial mega-cities like Polaris world and Marina d'or on the Mediterranean coast. The Spanish society is awakening from the dream of the rich life. Mariano Rajoy approved this week a draconian cuts package that includes a VAT increase, which will come into effect on September 1, as the Finance Minister Cristóbal Montoro informed. The government also approved 600 million euros worth of cuts in ministerial spending, the reduction of public servants' salaries and bonuses and a reform of the pensions system, among others.
But it seems that these measures didn't calm markets nor could they restore confidence. As Valeria Bednarik well said, “although there is a long list of challenges for Europe to face”, the first one will be to “restore the international credibility,” in order to recover full debt market access.
Checking the next chart, the pressure over the Spanish sovereign debt seems to continue and it event seems to get worse in line with the prices that Spain has been paying in the last months. The chart is clearly in an uptrend since February from the 4.9% paid for the 10-year bond to the current above 7.0%. It seems that the only way to ease high yields is ECB/EU intervention as it happened in August and November 2011. Remember that 7% is the frontier where countries like Greece or Portugal requested their bailout.
So, why debt costs haven't eased yet? Maybe it's not about trusting the austerity measures but a lack of confidence in the Spanish government and a lack of economic recovery ideas. The IMF expects a 1.8% contraction for the Spanish economy in 2012 and a weak 0.1% expansion in 2013. Market believe that with a recent €100 billion bailout (there are rumours about €400 billion rescue), debt cost at record highs and contraction in economy, Spain is going to enter a long recession tunnel, even depression.
The panorama might worsen: the unemployment is nowaday above 20% (50% young people) but the IMF is expecting it to rise to 25% by the end of the year. There is a lot of people who right now don't have any income or money to live. The crisis in Spain began in late 2007 and the first big wave of fired people was in 2008 with 2 years of welfare and extra 1-year no-income benefit approved by former president Zapatero, so people who were fired in 2007 and haven't been able to find another job have been receiving money from government for 3 years until 2010. Now think about the people that were fired in 2008 and then in 2009 and 2010.
With an unemployment rate around 20% it is not too hard to think about the social problems that could undergo the Kingdom of Spain after people getting fired in the last 5 years and without any income in the last 2. Spain certainly seems to be a time bomb and voices claiming referendum and revolutions are getting more numerous every day.
“Spain's most important challenges for this second half of 2012 are external and internal,” says Valeria Bednarik, FXstreet.com analyst. “For the outside, they have to restore investors’ confidence in their country, by working with their internal issues: budget cuts may not be enough to take down long term yields.”
“Rajoy needs to work to reduce as soon as possible the high unemployment the country suffers,” continued Bednarik, “without putting more extra weight on the common people shoulders, if he wants to stay long enough to rescue Spain.”
So Spanish claims, demonstrations and disorders are a big challenge in the Euro area as far as market will pay close attention on how the government will deal with it and how Mariano Rajoy will listen what the people is asking for. In addition market will pay attention on growth measures and how it would work in the short time as well as how Spain will deal with its debt costs and its impact on the real economy.
As the following chart from the IMF shows, the Eurozone experiencies divergences in the countries economic performances.
Meanwhile Portugal (-3.3%), Greece (-4.7%), Spain (1.8%) and the likely bailouted Slovenia (-1.0%) will post contractions in its GDP in 2012, Germany and France (including Ireland with weak 0.5% growth) will rise in the current year but at a low pace. Germany and France will support current and future bailouts but if their growth is slow, there is a contraction risk in the biggest economies. If this occurs, debt cost in peripheral countries would jump and crisis would be in a jeopardize situation again.
In the below table, we can see world's sovereign debt yield as well as premium risk. The Eurozone has 5 countries in non-affordable debt cost and as we have seen before pressure cost is in the upside.
Along these lines, “the Eurozone’s fundamental troubles through the second half of 2012 will be very much the same as they were in the first half,” comments John Kicklighter, analyst from DailyFX.com. “Implementation of stimulus and integration programs.” In June, the latest “EU Summit implied very ambitious programs that could put a serious dent in crisis concerns if they are fully realized,” Kicklighter continues.
“That said, there are issues with all of those big ticket items,” Kicklighter adds. “The Common Banking Supervisor is expected to hash out sometime between September and the end of the year. This overseer is a noted prerequisite of allowing the ESM to directly bailout banks.”
After more than 20 summits in the last two years, the Ecofin finally agreed on significant steps towards fiscal and banking union and a firewall against market pressure on debt cost. Despite the firewall's almost failure (check Spanish debt chart as an example), the “movement toward a fiscal union as opposed to just a monetary union,” comments Ed Ponsi, President of FXEducator, will be “the biggest challenge for the euro zone in the second half of this year.”
“Then there is an issue with the suggestion that the ESM program could be used to provide support to sovereigns to prevent the conditions of a regular bailout reaction,” states Kicklighter. But it seems “to require the agreement of all the members. Officials managed to once again buy time without putting into action critical fixes.”
According to Sean Callow, currency analyst at Westpac after the June 29 meeting: "Agreement has been reached to allow the bailout funds EFSF and ESM to be tapped by countries that aren’t formally signed to lending programs which have strict conditions (Italy and Spain come to mind!).”
"So definitely some good news for risk markets here though it is not the “big bazooka” – the EU leaders did not place stress on the possibility of Euro bonds,” adds Mr. Callow.