Fathoming Spain's skywards spike

The euro crisis is once again dominating the headlines. Renewed talk of a Greek exit, record yields for Spanish bonds and rising Italian borrowing costs have been splashed all over newspaper headlines. On July 25, the yield on two year bonds for Spain hit more than 7 per cent, with the borrowing cost for both the five year and ten year bonds exceeding 7.5 per cent. For Italy the rates were 5.2 per cent, 6.5 per cent and 6.7 per cent respectively.

Then, on July 26, as Mario Draghi, the ECB president spoke of doing "whatever it takes” to save the euro and making a reference to tackling problems of transmission of monetary policy being within the ECB's mandate, the yields fell sharply. In this policy commentary we discuss 1) the relevance of high yields and 2) how they may be brought down and 3) the relevance, if any, of Draghi's remarks.

No matter what the headlines say, the short-term impact of the rising yields on Spain's actual borrowing cost is very limited. Spain is currently paying just 4.1 per cent on the stock of its outstanding debt which has an average maturity of 6.4 years. This means that if Spain can now borrow at an average rate of say 7.1 per cent (a full 3 per cent points above current costs) it would take more than six years for this to reflect in its average borrowing costs. This means that in any one year its actual borrowing cost is likely to rise only by about a sixth of that amount, around 0.5 per cent. If the panic in the markets does not worsen (which is a big if) Spain's actual borrowing cost will only rise to a bit more than 4.6 per cent by July 2013 – which is a cause for concern, but not a cause for panic. What then is the problem? Why the near panic?

Why rising yields are a problem

The situation in Spain is very bad, but much more important is the fact that it is likely to get significantly worse unless current policies are changed dramatically. As the political space in the eurozone shrinks, this looks unlikely so not only does tomorrow look worse than today but the day after tomorrow looks even worse than tomorrow, and there is no light at the end of the tunnel. Under such a negative overhang, few people expect bond yields not to go higher still as the credit risk in the economy rises.

This gets us into a circular logic where expectations of the economy worsening drives both current yields and future expectations of yields high – these are a cause for concern and every time a new level, say 7.5 per cent is breached expectations set in that the next psychological threshold may be next. The absence of any eurozone policy maker response every time a new level is breached further reinforces the belief that the situation will get worse. (An ECB response has been expected as yields reached new highs, but did not come. This is one of the reasons why Draghi's remarks were initially interpreted positively by markets as he did address the issue, albeit indirectly, and the markets hoped that this was a precursor to action.)

The renewed discussion of a Greek exit from the eurozone poses potentially the biggest threat to Spain and Italy. As long as the euro is considered to be permanent, the mains risks in Spanish and Italian bonds are credit risks. The minute an individual seriously starts considering the possibility of a break-up of the eurozone, the additional risk of a currency reissue creeps in. Most Spanish and Italian bonds were issued under domestic law so in the event of a break-up of the euro, could be reissued into the peseta and the lira respectively. These are rightly expected to depreciate sharply, perhaps by as much as 50 per cent, consequently inflicting a very large loss on bondholders. This means that foreign investors, in particular, have a strong incentive to flee and the uncertainty overhang surrounding the integrity of the eurozone has been a big driver of capital flight from and rising yields in both the public and private sectors of Spain and Italy.

Rising yields have an immediate impact on the real economy as well as the financial sector beyond the market logic and dynamics we just discussed. First, rising yields depress the market price of the large amounts of Spanish government bonds held by Spanish banks that weakens what is already a very fragile financial sector. This in turn casts a negative shadow on the Spanish sovereign given that Spain will need to backstop most of any losses that may accrue in the banking sector. Second, rising yields and higher volatility increases the collateral haircuts that counterparties demand making life harder still for banks. Third, sovereign yields remain critical for the transmission of credit to the real economy.

Beyond the immediate negative impact that further fragility in the financial sector has on the ability and willingness of banks to lend to the real economy, sovereign yields continue to provide a de-facto floor for borrowing costs for large segment of the real economy. The fact of the matter is that the transmission channel for monetary policy in the eurozone has been broken – no one in the troubled eurozone economies can borrow anywhere close to the ECB policy rate. Credit is too expensive in the troubled economies and too cheap in economies such as Germany which the crisis has not hit yet. This pro-cyclicality is hugely damaging. In countries such as Spain and Italy the price of credit is rising and its availability shrinking weighing negatively on asset prices as well as real economic activity. Both of these further reinforce the downward economic spiral weighing negatively on the financial sector.

This leads to the emergence of what we have called ‘a dumbbell trap' in the eurozone, wherein the divergence of yields between weaker and stronger economies has a self-fulfilling dynamic of entrapping the eurozone in a bad equilibrium. The possibility of a break-up of the eurozone feeds this dynamic further since the currencies of weaker countries are expected to depreciate and those of stronger countries are expected to appreciate fuelling incentives to move money from the former to the latter.

The economics of the dumbbell trap has further consequences, making the politics of any solution to the euro crisis much more difficult. As the economies diverge more, the more likely any solution would be seen as being redistributive; making the already poisonous politics in the eurozone even worse. The capital that is fleeing Spain and Italy driving the yields there to record highs is fleeing to safe havens such as Germany depressing yields there to record lows. This rising yield divergence is yet another reason why current levels of Spanish and Italian yields are very damaging.

Another thing of note is both the reason behind the spike in short-term Spanish yields in particular and the possible impact of such a spike. Spain faces large near-term uncertainty as the eurozone leaders are unable to come up with a coherent response to the crisis. Renewed talks of a Greek exit further add to this uncertainty.

The logic is that the biggest dangers to the Spanish economy lie just ahead. It is clear that without a change in the dynamic of the eurocrisis these dangers are very real and rising. The corollary to this is that for Spain to make it through the next years successfully, a stemming of the eurocrisis is essential. That is why the borrowing costs for Spain for 2 years, 5 years and 10 years are very close to each other (the yield curve has flattened) as the assumption is that Spain will only be able to navigate the two years with a successful resolution of the euro crisis.

Most default risk for Spain or the risk of a break-up of the euro is thus concentrated in the near term. However the spike in short-term yields, no matter how logical, could create some serious problems of their own. Not least amongst them is the fact that governments use short-term borrowing for liquidity management in the same way that companies use current accounts. Losing access to this market creates a serious danger of the government accidentally running out of cash and missing payments to domestic or international creditors, which would be disastrous.

While the discussion above applies most directly to Spain, the logic therein also applies to Italy, with the key differences being that Italy does not have banking problems that are anywhere nearly as serious as Spain, that it has a primary surplus not a large deficit and that it has significant net private wealth unlike Spain.

Sony Kapoor is a former investment banker, derivatives trader, and adviser to governments and international organisations.

This piece, the first in a two-part series, is the edited extract of an article first published by re-define.org. Reproduced with permission.