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November 25, 2011

Europe Downgrades and Death Spirals

1. WSJ - Ratings agency Moody’s Investors Service downgraded Hungary overnight to non-investment grade category with a negative outlook, citing rising uncertainty about the government’s plans to reduce the budget deficit and public debt. Hungary is one notch from junk status at the other two major rating agencies, Standard and Poor’s and Fitch, with a negative outlook.

“Moody’s did not mention the political situation in Hungary, but in our view the erratic behavior of the Hungarian government is a serious risk to the country’s credit rating and the government’s unorthodox and damaging economic-political measures are clearly scaring away international investors. In fact, we think that more rating agencies are likely to downgrade Hungary, citing the strongly interventionist and populist rhetoric and actions of the Hungarian government.”

Lars Christensen, chief analyst at Danske Bank

“Moody’s downgrade of Hungary to junk status is the clearest indication yet that the financial and economic vulnerabilities of central and eastern Europe are being magnified as the crisis in the euro zone escalates. The pressure points are high loan to deposit ratios, high exposure to trade in the euro zone and high levels of foreign currency-denominated debt. Hungary fares particularly badly in all three areas.”

Nicholas Spiro, managing director at Spiro Sovereign Strategy




2. Spain has been the biggest victim of cheap capital from over-leveraged German, Dutch, and French banks. It was further destabilised by the loose policies of the European Central Bank.

Lest it be forgotten, the ECB allowed the euro zone's M3 money supply to rise at double-digit rates in the middle of the last decade (against a target of 4.5 per cent) to lift Germany out of slump.

More than any other country, Spain exposes the lie behind the German narrative. It did not cheat, like Greece; it did not breach Maastricht's 60 per cent debt ceiling like Italy (or Germany itself); its public debt was 36 per cent of gross domestic product before the Great Recession; it ran a budget surplus of almost 2 per cent of GDP in 2007 and 2008.

We can all agree that Spain has been far too slow to dismantle its Franco-era apparatus of labour privileges, or to end the inflation-linked wage rises eating away at intra-EMU competitiveness.

If Germany genuinely wishes to save Spain and Italy, it must allow EMU-wide reflation and mobilise the ECB as a lender of last resort to halt the bond crisis. To create a currency without such a backstop is criminally irresponsible. If this role is illegal under EU treaty law - and that is arguable - then EU treaties must be changed immediately.

If Germany cannot accept this for reasons of sovereignty or ideology, it should accept the implications and prepare an orderly break-up of monetary union. That is the only honourable course.

3. Point and Figures - The only countries in Europe that aren’t junk are probably France and Germany. However, without knowing the true exposure of their government finances to the rest of the EU, it’s hard to know if they can maintain their status or not. As rates continue to steepen in weekly European Union debt auctions, the entire continent speeds it’s collision course with stagflation.

The only way out of their financial mess is print money or grow. They aren’t going to grow given their current economic policies. Watch the near term months in the Eurodollar ($GE_F) contract. If they start to break hard, EU banks and governments are having funding problems.

As we mark time to the eventual day of reckoning, December 1 seems like the next big data point to me. It’s the date of the next French OAT auction. Spreads between French and German debt are at all time highs. As the PIIGS careen upwards to 8%, I don’t see how the French can keep their debt costs from spiraling higher as well.

4. Awful italian bond sale puts more stress on Euro Zone
Italy paid a record 6.5 percent to borrow money over six months on Friday and its longer-term funding costs soared far above levels seen as sustainable for public finances, raising the pressure on Rome's new emergency government.

The auction yield on the six-month paper almost doubled compared to a month earlier, capping a week in which a German bond auction came close to failing and the leaders of Germany, France and Italy failed to make progress on crisis resolution measures.

Though Italy managed to raise the full planned amount of 10 billion euros, weakening demand and the highest borrowing costs since it joined the euro frightened investors, pushing Italian stocks lower and bond yields to record highs on the secondary market.

Yields on two-year BTP bonds soared to more than 8 percent in response, a euro lifetime high, despite reported purchases by the European Central Bank.

In a sign of intense market stress, it now costs more to borrow for two years than 10 on the secondary market and borrowing costs for whatever term are above the 7 percent threshold, over which Italy is likely to need outside help if they do not subside.

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