So last year, I advised buying gold as a hedge against the potential turmoil that was to unfold in the Eurozone debt markets (Bailouts and fiat currencies, 13 April 2011). A sharp risk in risk aversion sent the price of the yellow metal up a third to an all-time high a few months later. At the time I also felt that equity markets would struggle to make any further headway without another dose of monetary easing (Watching the Fed, 23 May 2011) and a week later advised taking risk off the table one week later (Risk taking, 1 June 2011).
A year later, and here we are again. The liquidity pumped into the banking system by the major central banks in the past six months has not addressed the fundamental issue at the centre of the ongoing crisis: developed market economies have too much debt; too many banks and individuals are too highly geared and both have too little in the way of assets to support themselves comfortably. All the money-printing has done is to help inflate asset prices in the near-term and fuel rallies in risk assets.
As soon as the sugar rush wears off, risk aversion rises, asset prices deflate and investors return their focus back to the real issues facing developed economies. Right now, the real issue is Spain, which I forecast would be the next domino to fall over a year ago.
The time bomb that started ticking when the country's ruinous property bubble began to deflate is now close to detonating. The country has spent €19bn bailing out its third largest lender, Bankia, and credit rating agency Fitch has just downgraded Spanish sovereign debt to BBB - a mere two notches above junk status.
Fitch thinks a state bail out of the country’s banks is likely to cost €60bn (£49bn) and could potentially rise to €100bn, or three times the “baseline estimate”. That could be wishful thinking as economic consultancy Roubini Global Economics calculates that a recapitalisation of Spain’s banks would need an eye-watering €250bn of new capital - and with 10-year bond yields well above 6 per cent, the country deep in recession and running a sizeable budget deficit, a recapitalisation on this scale is beyond Spain without some external help.
Combining the bill for sorting out the banks with the government’s ongoing funding requirements, and the final tally could soar to as much as €450bn according to some analysts. To put this into perspective, the combined firepower available from the European Financial Stability Fund (EFSF) and European Stability Mechanism is only €500bn net of all prior obligations for the bail-outs of Ireland, Portugal and Greece.
But even that understates the task at hand. That’s because as soon as Spain formally asks for help, then it would shunt its burden of the EFSF onto the other members of the fund. Italy, France and Germany would in effect be backstopping 80 per cent of the EFSF’s share of the bail-out. And don’t think for one minute that the Chinese are going to help - they are now shunning Eurozone bonds altogether.
The one saving grace is that it’s still in Germany’s financial interest for the euro experiment to stay together, even if the population balks at the escalating costs of the bail outs. Analysts at Carmel Asset Management calculate that factoring in the fall in exports for Europe’s manufacturing powerhouse, private bank losses and its share of the two rescue funds, Germany’s total bill for saving the eurozone would be around €579bn.
That's a lot, for sure - but the analysts calculate Germany would be sitting on losses exceeding €1,300bn if the euro fell apart, including €637bn of Bundesbank losses on Target2 balances held in the European banking system. Looked at that way, increasing its share of the EFSF from 29 per cent to 33 per cent to rescue Spain is a price worth paying.
That is why I think a rescue for Spain will be forthcoming. However, it has to be credible enough to create a firewall and stop the contagion spreading to Italy. If it isn’t, then we should brace ourselves for heightened market volatility - the only cure for which is another round of money-printing from the US Federal Reserve, European Central Bank and the Bank of England.
