The Swedish lessons for Europe

Fiscal austerity is the current buzzword in macroeconomic policymaking. Across Europe, despite very strong domestic political opposition, governments have embraced wildly ambitious fiscal adjustment targets in an attempt to rein in soaring public debts, restore market confidence, and thereby engineer economic recovery. 

However, evidence from nearly three years of such experimentation across Britain and the Eurozone economies has been dismal. Bond markets have remained unimpressed and sovereign bond yields continue to rise. Not only have the expected recovery not materialized, but these economies have slipped further down the abyss. And this has been the fate of economies within and outside the Eurozone. The latest casualty is Britain, which has officially slipped into a double-dip recession, its second recession in three years. It joins Belgium, the Czech Republic, Greece, Italy, the Netherlands and Spain who are already in recession.

As with Greece, Ireland, and Portugal earlier, Spain too is now experiencing the wages of the same austerity medicine. Amidst a contracting economy, its sovereign debt rating has been downgraded and cost of borrowing has been rising. One-in-four Spaniards are unemployed and half all Spanish youth are out of work, both the highest among advanced economies. Even with all the belt-tightening, Spain is expected to easily miss its target of lowering budget deficit from 8.5% of GDP to 5.3% in 2012 and do no better than 6.2% .   

As could have been anticipated, the blind embrace of austerity has had the effect of accepting the worst of all worlds. As economic growth has contracted, public debt-to-GDP ratios have gone up even higher and tax revenues have dipped sharply. In the absence of either the private sector or external sector stepping in top stanch the space vacated by public expenditures, it was natural that the economy would contract.

All this has raised unemployment rates and inflicted untold suffering on citizens across Europe. Economic hardship have triggered off pent-up social tensions. Political rebellions and protests have become commonplace in these countries. Many governments have lost power in the face of street protests and failures to push through the tough fiscal adjustment measures required to secure external funds. At last count governments in Greece, Ireland, Italy, Portugal, Spain, Netherlands, and now Romania have lost power due to the pains caused by spending cuts.     

In this context, it has become important that these economies abandon their dogmatic ideological embrace of austerity and fall back on policies that can get their economies growing. Robert Samuelson has a nice article which highlights the less-discussed economic turnaround of Sweden since its banking crisis induced economic recession in early nineties. In recent years, Sweden has emerged, along with Germany, as among the best performing developed economies.

Instead of being wedded to ideology-driven policies, Sweden embraced prudent policies that combined both the conservative and liberal social and economic agendas. For a start, it did not bail out its banks but forced them to take massive losses and virtually nationalized its banking sector. The real estate bubble that was inflated by the financial deregulation of the 1980s deflated in 1991-92. As pressure mounted on the krona, overnight interest rates spiked to 500%, and the Swedish economy contracted steeply and unemployment quadrupled in three years to 12%. After a series of bank failures, the government moved in swiftly with a series of measures,

In September 1992... the government announced that the Swedish state would guarantee all bank deposits and creditors of the nation’s 114 banks. Sweden formed a new agency to supervise institutions that needed recapitalization, and another that sold off the assets, mainly real estate, that the banks held as collateral. Sweden told its banks to write down their losses promptly before coming to the state for recapitalization. Facing its own problem later in the decade, Japan made the mistake of dragging this process out, delaying a solution for years...

By the end of the crisis, the Swedish government had seized a vast portion of the banking sector, and the agency had mostly fulfilled its hard-nosed mandate to drain share capital before injecting cash. When markets stabilized, the Swedish state then reaped the benefits by taking the banks public again.

This was followed with several far-reaching structural reforms that turned the largely statist economy into one of the world's most dynamic economies, without compromising on its social-democratic principles. The reforms drew from both the conservative and liberal playbooks,  

Sweden’s income tax base was broadened and tax rates were sharply reduced (marginal tax rates fell from 46% in 1996 to 33% in 2010). Spending was cut on old-age pensions, child allowances, unemployment benefits and housing subsidies. Union power over wages was reduced. Many markets (banking, air travel, telecommunications, electricity production) were deregulated. Low inflation and balanced budgets became broadly embraced popular goals...

Although Sweden trimmed social benefits, it hardly abandoned the welfare state. Overall government spending is still about 50 percent of the GDP, much higher than in the United States... To reduce income tax rates, the government raised other taxes. Gasoline and cigarette taxes were increased; so were taxes on dividends and capital gains, hitting the rich. Altogether, deficit reduction totaled a huge 12 percent of GDP from 1991 to 1998. Slightly more than a third of that came from higher taxes...

The aims were clear: to reward work by cutting income tax rates; to push people back into the labor market by reducing some government benefits; and to promote productivity by increasing competition. Productivity and “real” (after-inflation) wage gains improved markedly. Still, Sweden has less economic inequality than most advanced countries.

Sweden also benefited from favorable external economic conditions. Its recession coincided with a sustained period of economic strength across much of the world. Sweden could therefore export its way out of recession. A 25% devaluation of the krona boosted exports. Unfortunately, none of the peripheral European economices today can afford this luxury. None of the Eurozone economies have the freedom to undertake this policy route. See also this excellent presentation by Swedish Finance Minister Anders Borg.

The choices facing Eurozone governments are stark. Currently the austerity policies are merely pushing their economies down the hill, with no hope of finding an anchor that can drive economic recovery in the foreseeable future. It is necessary for all the Eurozone economies to start regaining their economic competitiveness for any sustained recovery to take hold. This can happen only with either a Eurozone exit and/or fiscal transfers from the Eurozone's center. There has to be some period of fiscal accommodation in the periphery and consumption increase in the center.

This is an opportunity to push through the tough labour market liberalization and industry dergulation policies that have for long contributed to sclerosis in Europe. More than that it is an opportunity for the Europen monetary union to become a loose political union, a necessary requirement for the continent to stave off similar situations in future, leave alone escape the current mess.   

Is the global "safe assets" bubble bursting?

The 10-year German bund and US T-Bond are ruling at historic low yields. As the graphics below indicates, the yield on German bund is slightly below 2% while that on US Treasuries is slightly above 2%.




Obviously, especially with the US, fundamentals cannot explain the historic lows. The US economy is just emerging out of a deep recession and there are serious question marks about the sustainability of this recovery. The German economy, while strong in comparison to its crisis-ridden Eurozone partners, faces serious external threats.

The widely accepted explanation for this historic-low sovereign bond yields is their role as perceived "safe-havens". Since the sub-prime mortgage bubble burst, the US Treasuries have emerged as the preferred safe and liquid asset for investors world-wide. America's burgeoning public debt and anemic economy has not prevented capital flight from emerging economies and elsewhere into US Treasuries, driving down their yields. Similarly, across Europe, once the real depth of problems faced by the peripheral economies became apparent in early 2011, the German bunds have emerged as the preferred safe haven.

In the US, apart from this, the Fed, through its quantitative easing and "Operation Twist" programs, played an active role in driving down longer-term sovereign debt yields in order to stimulate the economy.

Consequently, both assets have been driven to ultra-low rates. While this has helped both countries, especially the US, access foreign capital at cheap rates, and thereby reduce the impact of their real debt burden, it has had all the effects of an asset bubble in both countries.

Banks in US and Europe have stacked up massive quantities of German bund and US T-Bond. In fact, at these ultra-low rates, banks were effectively paying money to both central banks in return for the safety and liquidity these assets provided. Investors and hedge funds spent huge funds to buy into both securities to take advantage of its rising values. It appeared to offer them both risk assurance and handsome returns. An asset bubble in both these securities has been the inevitable result.

This trend has mirrored a similar rise in yields across their partners, especially among the Eurozone economies. The spreads with German bund of the peripheral Eurozone economies have risen sharply. Bond yields have risen in many emerging economies too as the global economic uncertainty increased.

That this is a full-blown bubble is borne out by the fact that sovereign bond yields on both securities are at their lowest for more than 40 years and nearly 25 years for US T-Bond and German bund respectively. Therefore, it is inevitable that these yields have to rise considerably before global bond markets regain their balance. The recent fall in the prices of both bonds, while very small, may be the trigger for the bursting of the US-German sovereign bond bubble.

With the world economy on the recovery path and Eurozone troubles appearing to have crossed its worst, the global bond markets are looking up. This would reduce the premiums associated with safe-havens and thereby set the stage for returning the German and US sovereign bond yields to their normal valuations. Though this will create its own set of problems, especially for banks which have stocked up with these safe assets, it bodes well for the long-term global macroeconomic balance.

The dismal European landscape

One of the most contentious debates surrounding the sovereign debt crisis in Europe is that about the institutional mechanism to provide the necessary liquidity support to the embattled economies.

The European Central Bank (ECB) is not empowered to provide the unconventional monetary policy actions that the Fed did in the US and thereby backstop losses and unfreeze credit markets as a lender of last resort. Further, there is strong ideological and political opposition to printing money to buy the debts of individual members for fear of stoking inflation.

Therefore, as a compromise, the Eurozone leaders had established the European Financial Stability Fund (EFSF) to provide financial assistance to these governments. The IMF joined hands with the EFSF in structuring a first round of Eurozone financial stabilization fund of 440 m Euros.

Its mandate and firepower was designed with the objective of rescuing Greece, Ireland and Portugal. However, now with the turmoil spreading to Italy, Italian bond yields crossing the seven percent mark, and the country facing the danger of losing market access, the stabilization fund clearly looks under capitalized. A "big bazooka" appears necessary.



There is also a growing realization, given the magnitude of market uncertainty surrounding the Eurozone, that the current liquidity crunch being faced by otherwise sound economies like Italy (and maybe France later) could turn into a solvency crisis. And if this happens to the country with the fourth largest public debt, it will be the final nail in the Euro project and have devastating consequences for the world economy itself. The frantic search for possible solutions to provide adequate liquidity cover for Italy is understandable. Nouriel Roubini writes,

"Once a country that is illiquid loses its market credibility, it takes time – usually a year or so – to restore such credibility with appropriate policy actions. Therefore unless there is a lender of last resort that can buy the sovereign debt while credibility is not yet restored, an illiquid but solvent sovereign may turn out insolvent. In this scenario sceptical investors will push the sovereign spreads to a level where it either loses access to the markets or where the debt dynamic becomes unsustainable. So Italy and other illiquid, but solvent, sovereigns need a 'big bazooka' to prevent the self-fulfilling bad equilibrium of a run on the public debt. The trouble is, however, that there is no credible lender of last resort in the eurozone."

One option which has found favor with a number of opinion makers but has been rejected by Germany and the ECB is to issue Eurobonds. It is argued that such bonds, issued initially through the EFSF, could simultaneously solve two problems. One, it would help raise the cash required to refinance the debts of countries finding it difficult to access the debt market. Second, it could complement the German bund and provide an alternative risk-free investment avenue. Such assets can help stabilize the financial markets by providing investment avenues for institutional investors to rebalance their portfolios as they exit the struggling peripheral economy bonds.

In an FT article, Wolfgang Münchau has rejected the notion of leveraging the EFSF to purchase Italian and other PIIGS debt. He describes his Eurobond proposal,

"The EFSF could announce that it would make unlimited purchases of national sovereign bonds to keep their spreads under an agreed cap – say 2 per cent for 10-year bonds. The European Central Bank would refinance the EFSF for as long as it takes. Once the Eurobonds are in place, EFSF liabilities would simply be transformed into Eurobonds. This would not constitute an illegal monetisation of debt, as long as the endgame for the EFSF is credible."

But there are strong reasons to cast doubts on success with the Eurobond plan. For a start, the issuance of Eurobonds would require changes to the Treaty itself. Before that could happen, it would have to overcome entrenched opposition in Germany. Further, it will consume valuable time. After this even if it arrives, it may be too late to save the monetary union.

In any case, monetary policy support is only one side of the policy requirement spectrum. Another formidable challenge facing the new Italian government involves the fundamental restructuring of the economy, especially its labor market. The country has lost labor cost competitiveness against Germany by more than 50% since the mid-nineties. The reforms required include dismantling the two-tier jobs market, which protects the jobs of older workers in dying industries but traps youngsters in temporary work; and the industry-wide wage bargains that mean businesses cannot match wages to productivity. The closed-shop professions and trades, and the mircro-sized family businesses, are a barrier to innovation and efficiency. The business landscape which is dominated by small firms should accommodate more bigger sized firms. The pension system should be further reformed and a clampdown on tax evasion enforced.

However, as Nouriel Roubini writes, structural reforms like raising taxes, cutting spending and getting rid of inefficient labour and capital during structural reforms have a negative effect on disposable income, jobs, aggregate demand and supply. The recessionary deflation that Germany and the ECB are imposing on Italy and the other periphery countries will make the debt more unsustainable. He feels that there can be only one denouement,

"Even a restructuring of the debt – that will cause significant damage and losses to creditors in Italy and abroad – will not restore growth and competitiveness. That requires a real depreciation that cannot occur via a weaker euro given German and ECB policies. It cannot occur either through depressionary deflation or structural reforms that take too long to reduce labour costs.

So if you cannot devalue, or grow, or deflate to a real depreciation, the only option left will end up being to give up on the euro and to go back to the lira and other national currencies. Of course that will trigger a forced conversion of euro debts into new national currency debts...

Only if the ECB became an unlimited lender of last resort and cut policy rates to zero, combined with a fall in the value of the euro to parity with the dollar, plus a fiscal stimulus in Germany and the eurozone core while the periphery implements austerity, could we perhaps stop the upcoming disaster."

Even without going into any of these, the details of sustainably financing and paring down its massive public debt of €1,900bn (120% of GDP) is frightening. This problem, difficult in normal times, is amplifed by a weak economy (it is the only major economy where per-capita GDP declined annually in the 2001-10 period) and severe austerity measures. Though much of its debt is short-term, as much as €350 bn of debt comes due next year. An FT article argues that any increase in bond yields (and therefore cost of capital) will weaken the economy and deepen the debt crisis,

"The impact of crisis interest rates is likely to increase the annual debt burden by less than 1 per cent of GDP next year, compared to what would happen with 'normal' interest rates... With medium term nominal GDP growth likely to be in the doldrums at 2 per cent per annum, interest rates at 6.5 per cent would mean that Italy needs to run a primary surplus of 5.5 per cent of GDP indefinitely in order to stabilise its debt/GDP ratio at 120 per cent."

In simple terms, if Italy is to make a significant dent on its public debt problem, it will have to pull off reforms that ease the economy into a growth path that can create a primary budget surplus of over 5% of GDP for several successive years. And all this with a depressed economy, weakness among major trading partners, and a severe bout of austerity. As the FT writes, "If such a large fiscal consolidation can be achieved in the teeth of a recession, it will be very impressive, to say the least".

Update 1 (28/11/2011)

Wolfgang Munchau offers a three pronged approach to resolving the Eurozone crisis. First, aggressive intervention by ECB to provide massive temporary short-term liquidity and unlimited guarantee of a maximum bond spread or a backstop to the EFSF. Second, end the current process of cross-broder national guarantees and float joint-and-several liability eurozone bonds of credible size. Third, a fiscal union.

From hope to despair in a week?

It was just a week back that the markets were celebrating a much debated deal to bailout Greece in return for structural reforms and austerity and provide liquidity support for beleaguered European banks. Then on Monday, faced with strong public opposition, George Papandreu stunned everyone by deciding to call for a referendum on the austerity and bailout deal agreed with the other Eurozone members.

For all practical purposes, this referndum would be a vote on whether Greece should stay or leave the Eurozone. In fact, the Times quoted the German Chancellor Angela Merkel who has described the referendum as "about nothing else but the question, does Greece want to stay in the euro zone, yes or no?"

It heightens the risk of a sovereign default by Greece and even a possible Euro-exit and return to Drachama ending a 10-year experiment with the Euro. The big question facing policy makers in Athens and Brussels is whether the benefit of having a cheap currency under Greek control would outweigh the costs of defaulting on its debt and abandoning the euro. More worryingly, it threatens to unravel the comprehensive debt deal reached last week to shore up Eurozone economies and thereby endangering the Italian economy with potentially catestrophic consequences for the world economy itself.

Over five of the most volatile trading days, Greece has seen the best and worst of financial market volatility. Greek CDS spreads fell from 5500 points to 3100 points and then has risen to 5600 points, all in the space of five trading days.



The yields on 10 year Greek bonds too have risen steeply, cancelling off gains from the debt deal.



Update

From despair, there arises some hope as the Greek Prime Minister musters opposition support for the debt deal and calls of the proposed referendum, thereby taking his country away from the edge, atleast for the time being. Adding more cheer for the markets, the ECB, under its new President Mario Draghi, cut its benchmark rates by 25 basis points to 1.25%

A graphical summary of the state of Indian Economy

Inflation has remained elevated at 8-10% range for more than 18 months since March 2010. Though the RBI and government have predicted the subsidence of headline inflation for many months now, it remains persistent at these high rates. The RBI's second quarter monetary policy review has projected baseline inflation to be 7% by end-March 2012.



Since February 2010, the RBI has increased rates 13 successive times, the largest such sequence of increases in its history. The repo and reverse repo rates have risen by 375 and 425 basis points respectively during this time.



Adding to the pressure is the steep recent depreciation in the value of rupee. While beneficial to exporters, it has the potential to add to inflationary pressures by making imports, espcially of oil, costlier.



In a reflection of the tightening monetary conditions, anchored inflation expectations, and increased government borrowings (government recently announced an increase in its 2011-12 fiscal borrowing by an additional Rs 52,872 Cr, taking it to a record Rs 4.7 trillion), long-term interest rates have been climbing. Into this milieu the announcement by the government The yields on 10 year government bonds have increased by more than 80 basis points since the beginning of the year.



As a measure of the growing global financial market instability, India VIX, the barometer of equity market volatility, has not only risen but has shown increased fluctuations over the past three months.

Euro distress signatures

Here is a comparative assessment of the panic affecting Greek, Portuguese, and Italian government debt instruments. The spreads between the 10 year sovereign bonds of each of these countries and the German Bund had started widening since April and has gathered momentum since July.



The yields on ten year sovereign bonds too have increased sharply over the past month or so.



The cost of insuring Greek, Portuguese, and Italian debt, reflected in the 5 year CDS spreads, too have followed much the same pattern, exploding in the past two months.

Negative interest rates in Switzerland

Amidst all the turmoil in Europe and the global financial markets, a less reported but remarkable event happened when the Swiss interest rates, including medium-term rates, in the LIBOR market plunged into negative territory. In other words, instead of being paid by their borrowers, lenders would now have to pay for the privilege of getting borrowers to accept their money!



As the Eurozone economies plunged into crisis, Swiss Franc emerged as a possible safe haven. The resultant capital inflows boosted the Franc by over 20% against the Euro, hurting Swiss exports and economic growth. In fact, as Gillian Tett writes, the Goldman Sachs has described it as "the most overvalued currency" in recent history, 71% stronger than fundamentals justified.



In response, early this month, the Swiss National Bank (SNB) acted aggressively to lower interest rates to virtually zero (from 0.25%), inject unsterilized cash, build up sight deposits (cash withdrawable on demand from the central bank) with the SNB, and repurchase outstanding SNB bills and use the proceeds to buy Euros in the forex market. The SNB press release said,

"Effective immediately, the SNB is aiming for a three-month Libor as close to zero as possible, narrowing the target range for the three-month Libor from 0.00-0.75% to 0.00- 0.25%. At the same time, it will very significantly increase the supply of liquidity to the Swiss franc money market over the next few days. It intends to expand banks' sight deposits at the SNB from currently around CHF 30 billion to CHF 80 billion. Consequently, with immediate effect, the SNB will no longer renew repos and SNB Bills that fall due and will repurchase outstanding SNB Bills, until the desired level of sight deposits has been reached."

The results of this aggressive response has been spectacularly successful, with interest rates on Swiss two and three-year government bonds falling into negative territory and spreads with German bund widening on the negative side. The Swiss ten year bonds have fallen off precipitiously in the last two months. The futures markets are currently predicting negative rates until 2013 and minus 8 basis points next summer.











This effectively means that "if you want to lend Swiss francs or make a deposit in the next year, you must pay for that privilege", an anomaly that has led to Gillian Tett of FT to describe it as "Alice in Wonderland" economics! Alternatively, anyone holding two-year or three-year Swiss bonds is now demanding that the price exceeds the coupon-included return in order to be tempted to sell.



Apparently, this is not the first instance of negative interest rates. In the 1970s the SNB imposed negative interest rates on foreign accounts to deter inflows; and in 2008 some short-term Swiss market rates briefly turned negative. That also happened in Japan in the late 1990s and recently some dollar short-term rates have touched negative territory. However, in all these cases, the negative rates covered only ultra-short rates, whereas the present Swiss situation is for medium-term rates covering the next two years. In simple terms, borrowers could take out a two-year loan with the assurance that they would need to be paid by the lenders for the next two years.



However, given the depth of the financial crisis, as FT Aplphaville says, even this situation is fraught with dangers. Technically, the build up of sight deposits (which would be used as reserves by banks) should "cause Swiss rates to fall sharply since the more reserves banks hold, the less they require to borrow from each other and the lower the rate falls". FT Alphaville writes about the distortionary possibilities,

"Since the SNB pays zero on its sight deposits, there is a very real risk banks might be encouraged to hoard cash on deposit rather than to lend it out for a negative rate. This would be the exact opposite of expanding the money supply. It might even be contractionary.



Now, the SNB is probably hoping that the extreme unattractiveness of having to pay an additional rate to hold Swiss francs will be enough to encourage holders of the currency (especially those abroad) to sell the franc and move elsewhere. This, theoretically, should flood the market with Swiss francs, lowering exchange rates and easing liquidity. But there is still the danger that the move could drive Swiss francs straight into the coffers of Swiss-based banks, who would then be unwilling to lend them out at a negative rate.



In that circumstance, a deflationary spiral motivated by 'capital preservation' could begin. Once that starts, no matter how much 'QE' money is printed, it becomes completely ineffective at boosting the money supply. In fact, if anything, it arguably becomes a deflationary force because the money is being pumped directly into a liquidity trap, in which capital preservation (rather than yield) is the chief priority of banks and depositors. Which, by the way, happens to be exactly what happened during the Great Depression."

This has echoes of the Great Depression (see this Ben Bernanke paper), when "the market for unsecured lending died a death because counterparties no longer trusted each other",

"Everyone turned towards a collaterised lending regime, one in which only the very best collateral (Treasuries and gold) would do. This had the effect of causing a run towards Treasury securities. No matter how much money was printed by the Fed to ease liquidity concerns it only intensified the obsession with capital preservation. Largely by eliminating the number of Treasury securities in the market. Since, there was no one the banks could lend money to in the wider market due to credit concerns, Treasuries became a bit of a Giffen good. The money had to be parked somewhere... With capital preservation becoming the top priority for banks, institutions were willing to pay more than the face value of Treasury securities, because investing elsewhere would come with too great a risk of default."

In the uncertain environment, as the prices of Treasuries went up (and the yields fell down), banks purchased more of the same. The same story is being repeated today with Swiss Government Bonds, pushing yields into negative territory.



As an update, it does now appear that the SNB's aggressive actions have not been as successful as initially thought in curbing the Franc's rise.

Portugal follows, where is the "confidence fairy"?

So finally, after months of speculation, and faced with spiralling borrowing costs, Portugal bows to pressure and follows Greece and Ireland in seeking an emergency financial bailout from the European Commission. It is being estimated that the country would need about 75 billion euros ($106.5 billion) in assistance and the conditions of the assistance is expected to be worked out soon.

The bailout became inevitable after the steep increases in Portugese borrowing costs in the past few weeks.



There have been repeated downgrades by credit-rating agencies (twice last month alone) which have sent yields on Portuguese government debt to their highest levels since the introduction of the euro. Last week Portugal sold 455 million euros (about $646 million) in one-year Treasury Bills at an average yield of 5.9%, up from 4.33% since mid-March. Similarly, the yield on 550 million euros of six-month bills was 5.12% compared to just 2.98% in an auction in early March. The emergency financing will ensure that Portugal can meet its 20 billion euros of borrowing requirements for the year.

Last May, the European Ministers agreed to provide 80 billion Euros to Greece over three years as part of a package in which the International Monetary Fund provided an additional 30 billion euros. Then, in November, they also agreed to a rescue package worth up to 85 billion euros for the Irish government. Further, last month, following Greece's adoption of extensive austerity measures, they also agreed to cut the interest rate charged Greece to help ease its debt burden. However, Ireland's refusal to accede to French and German requests to raise its low corporate tax rate of 12.5%, has meant that no such benefits have been given to Ireland.

The bailout will be arranged from the eurozone’s €440 billion rescue fund, the European Financial Stability Facility, which was set up last year to meet such contingencies. It is being hoped that the Portuguese bailout request may help reduce the risk of contagion to other countries, most notably Spain, by ring-fencing the euro’s three weaker economies.

However, if Greece and Ireland are any evidence, the standard European prescription of fiscal austerity to get the "confidence fairy" singing again and the economy back on the growth track appears not to be working. In a clear indication that its fiscal austerity was not doing much, the sovereign ratings of Greece, which was already downgraded to junk status, was again lowered by S&P to BB– from BB+.

Also, the cost of insuring debts and cost of borrowing has been rising unabated for both Ireland and Portugal despite the severe austerity measures and the emergency bailout package. In fact, as the graphic shows, after a brief drop in the immediate aftermath of the May 2010 bailout, the 10 year bonds have risen from about 7.25% to 12.75 today, while the CDS spreads have doubled, touching 1000 points.



In case of Ireland too, the same story has been repeated with both bond yields and CDS spreads. In Ireland's case, the fiscal austerity, which has been much more severe and has been in operation for more than two years now. Inspite of this, the bond yields and CDS spreads have been rising unabated all the while.



However, fears about Spain being the next in the domino to fall may be slightly exaggerated, atleast for now. Its CDS spreads have fallen dramatically since the beginning of the year and bond yields too have remained stable, albeit at a high 5-5.5% range.

Update 1 (9/4/2011)

Underlining its hawkish stance on inflation, in an unanimous decision, the European Central Bank (ECB) raised its benchmark policy rate to 1.25 percent from 1 percent. Inflation in the euro area rose at an annual rate of 2.6 percent in March, up from 2.2 percent in February and above the bank’s target of just under 2 percent. Since October 2008, the ECB had, in response to the sub-prime crisis and Great Recession, slashed rates from 4.25 percent to 1 percent by May 2009.

This is in contrast to the Federal Reserve, which continues to stimulate the American economy, as well as the Bank of England, which early this week left its benchmark interest rate at 0.5 percent despite higher inflation. In fact, like the $600 bn QE II in the US, the Bank of England too is continuing with its £200 billion ($325 billion) bond-purchase plan.

The rate increase could have dire consequences for Greece, Ireland and Portugal, where they are already having severe problems borrowing money at reasonable rates. More worryingly, the rate hike will also increase the pressure on Euro to appreciate, thereby weakening the competitiveness of European exporters.

This Economist article points to the fact that unlike Greece, Portugal does not have the problem of mountainous public debts or recklessly leveraged banks. Its problem is more structural - lack of competitiveness manifested in high input costs and excessive bureaucracy. It is inconceivable that austerity can do anything to overcome these problems.

Update 1 (15/4/2011)

The British austerity plan (aimed at lowering its budget deficit from a high 10% of GDP) appears to be having its predicted impact - retail sales plunged 3.5 percent in March, the sharpest monthly downturn in Britain in 15 years; a new report by the Center for Economic and Business Research forecasts that real household income will fall by 2 percent this year.

Update 2 (20/4/2011)

Nice graphic on the EU's emergency bailout fund.



Update 3 (4/5/2011)

Portugal has accepted an international (EC, ECB and IMF) aid plan of 78 billion euros ($116 billion). Under the three-year plan, the deficit would need to be lowered to 5.9 percent of gross domestic product this year, 4.5 percent in 2012 and 3 percent in 2013. Last year, Greece secured a bailout package worth 110 billion euros and Ireland 85 billion euros.

Update 4 (16/2/2012)

Times chronicles how austerity is leading Portugal down the cliff. See also this Room for Debate on Portugal.

Re-coupled global financial markets

Even as the emerging and developed economies appear to be de-coupling from each other, there is growing evidence that their financial markets are getting more closely synchronized. Have the global financial markets become too-interconnected to fail? Are financial markets no longer useful in risk diversification?

An recent study by HSBC draws attention to the growing correlation between different markets and asset classes - equities, bonds, forex instruments, commodities etc - since the onset of the sub-prime crisis. They argue that the financial markets have become entrapped into a binary state of "risk on-risk off" strategy - all the financial market segments have been swinging in unison, believing that either the future is bright ("risk on") or that it is bad ("risk off"). Risky assets move up or down together. They characterize the present market conditions thus,

"1. Risk on – risk off must be the foremost consideration in any trading activity today.
2. Financial markets, and in particular portfolios, are not as diversified as they once were. Risk takers may be holding more risk in their portfolios than they realise.
3. In current market conditions, there is little point trying to understand the nuances between different asset classes, or the relative value within asset classes. Commodities behave like bonds, which behave like equities. They are no longer easily identifiable, uncorrelated trades, which should be borne in mind when developing new trading strategies."

While synchronization of disparate markets and "risk on-risk off" strategy is a feature of financial markets in the immediate aftermath of a major financial crisis, it persistence for an extended period now is causing concern among market participants. It is argued that the depth of blow suffered to the economic confidence has been so massive that the markets are taking much longer to recover its normal features.

The HSBC researchers use heat maps to identify the changes in correlations between different categories of asset classes. The dark red indicates strong positive correlation while dark blue is strong negative correlation, while green and yellow represents weak (or uncorrelated) negative and positive correlations respectively. The heat map below represents the normal and generally uncorrelated markets in 2005-06. At this time, correlations were strong only between same types of assets and the large share of assets were uncorrelated.



However, with time, the correlations have strengthened and we now have a strongly correlated market landscape. Observe the more widely dispersed streaks of red - indicating much increased correlations across disparate asset categories.



These correlations are far from static and are evolving over time in response to various triggers that move the markets. The changes in the market can be tracked by observing the changes in this heat map. The HSBC report argues that when normalcy returns, relative valuations between aseet classes will make a comeback and asset allocation and diversification will return.