After Spain got an ?unconditional? bailout from the EU, Italy is the most likely next candidate as euro crisis spreads. This is likely to be the beginning of the end for the eurozone as it exists today
Most of the problems the world is currently facing remain unresolved.
Even with the positive news of conclusive Greek election results, the cost of insuring against a Spanish debt default jumped 27 basis points to 622bps, equating to annual costs of $622,000 to insure $10 million of debt for five years. Italian CDS meanwhile rose sharply to 554bps, according to data provider Markit.
The expectation that we have secured resolution on the Greek melodrama with the electoral success of the mainstream New Democracy party is mistaken?Greece and its creditors could now bargain for months over the terms of the country?s euro 174 billion bailout. The election will still set in motion what could be days?even months?of nail-biting negotiations between Greece and its international creditors.
The prospect of lengthy coalition talks and then further negotiations between a potentially fragile government and Greece?s creditors will bring more of the uncertainty that has roiled financial markets in recent weeks, spreading sovereign debt crisis contagion to the much bigger economies of Spain and Italy.
During that time, markets would be pitched ?on a knife?s edge? as they scrutinise mixed signals emanating from an incoming Greek government and its creditors, with a euro 3.9 billion debt interest payment to the European Central Bank (ECB) looming in August. If the future of Greece?s international bailout is thrown into doubt, the ECB could deem Greek banks ineligible for its support. Germany?s Bundesbank has already signalled its impatience with Athens.
The EU has its own ?red lines?. The easing of the terms that would require more money for Greece would stir outrage among voters in Germany, the Netherlands and other creditor countries. International help remains vital for Greece?s banking system, meaning the ECB will play a central role in determining the country?s fate. The Greek financial system is reliant on ECB liquidity and a decision by the ECB to pull the plug could cause its collapse. If negotiations get bogged down, the EU may squeeze Greece. Member states withheld euro 1 billion from a loan disbursement last month, pending the outcome of the elections. Without such funds, Greece will not be able to pay salaries and pensions?let alone bond redemptions.
But squeezing too hard could backfire if it precipitates a debt default that shocks financial markets. Spanish bond yields, which have risen to dangerously high levels, will serve as a stark reminder of the European bloc?s vulnerability. Last weekend, Spain received EU support of a financial assistance package of euro 100 billion. This de facto bailout is roughly equivalent to 10% of Spain?s current GDP as compared to the $700 billion bailout in the US, which was 5% of GDP at that time. This was no small measure.
According to the Spanish economy minister Luis de Guindos, the bailout cash will go to the Fund for Orderly Bank Restructuring, which is set up specifically to fund insolvent banks. For Spain, this means that it will be completely absorbed by the massive levels of failing real estate loans. Since the ?bailout? will be a loan with better terms than the market, at 3% or roughly half of the Spanish government bonds, it will still result in a material increase in Spain?s total debt (national and European) to GDP, pushing it well past 140%. Of course, therein lies the real story. The bailout, in the eyes of sovereign creditors, just made the country a materially worse bet as Spain?s debt increases by up to 17% and the structure of the loan subordinates existing creditors. This is why we saw Spanish bond yields push higher after the bailout announcement was made.
So where is the money coming from? The EU announced that the sole source of cash would be the European Stability Mechanism (ESM) or the European Financial Stability Fund (EFSF). This is interesting when you consider that the ESM has yet to be ratified by Germany whose Parliament has been steadfast against allowing the ESM to fund a direct bank bailout like that is being proposed by Spain. Without German ratification of the ESM, which is highly doubtful in this case, and without having to give ESM bonds ?preferred creditor status?, the bailout will fall onto the EFSF, which currently retains only about euro 200 billion in liquidity. However, the dilemma is that Spain?s obligation to the EFSF is about euro 93 billion, which is now unlikely to be contributed, thereby leaving the EFSF with only about euro 7 billion after the bailout is complete.
With Spain getting an effective ?unconditional? bailout from the EU, it will just remain a function of time before more requests begin to be raised. Italy is the most likely next candidate as the euro crisis has spread, pushing borrowing costs to unsustainable levels as economic weakness continues to exacerbate the problem. This is likely to be the beginning of the end for the eurozone as it exists today. Spain?s bailout comes without the conditions that Ireland, Portugal and Greece were subjected to. Excessively restrictive targets on taxes, spending and social welfare have constricted their respective economies, sending them into sharp recessions.
Germany too is quickly running out of options. The dissension between Germany and the bailout recipients is rapidly growing as the continued fanatical ideologies that have been the backbone of the global delusion to ?solve the insolvency? of the EU?s financial system. That dissension, not only between the member states but within the political arenas themselves, is why the failed experiment of an European Union will eventually arrive at its final destination.
The headwinds facing global financial markets today are far greater than just the Spanish banking system. They include:
* The global economy is very weak and susceptible to external shocks.
* The eurozone will slow economic growth in the US?the only real question is how much?
* The ?fiscal cliff? in the US will have to be dealt with?but when and will it be too late?
* The debt ceiling debate is approaching, again.
* Emerging markets are slowing as well, putting more pressure on the US economy.
* Economic indicators are all beginning to show signs of increased weakness.
* The eurozone crisis continues with no real solution in sight.
* Corporate profits continue to weaken.
* Market valuations and price targets are still very optimistic considering the headwinds the world is facing at this point of time.
I believe a massive global sell-off in equities looks imminent in the near term.
The author is CEO, Global Money Investor
