Portgual Is Next

The Intervention of the ECB could not have been more timely. It pumped in another 530 Euros of money through the back door. Citigroup notes that this amounts to €316bn of fresh liquidity, stripping out renewal of old loans – more than the  €200 billion pumped in through this route in December 2011. Effectively it postpones the problems for upto an year, though the banks have been given three year low cost deposits. 

Even as the ECB keeps pumping in more money, it has been pointed out that the real M1 depostis in peripheral Europe are still in a downward spiral, with falls of 12.9pc in Greece, 9.2pc in Ireland, 9pc in Portugal, 8pc in Italy and 1.5pc in Spain over the past six months alone -- implying double-digit falls at an annual rate.

The crisis in Greece has drawn attention to yet another country, Portugal,  that is now going exactly the same way as Greece. The country is gradually being shut out of the bond markets. Portuguese 10 year yields have hovered around 13%: down after briefly crossing 17% in late January. The decline is associated more with ECB buying Portuguese bonds rather than any improvement in the perception about the economic health of that country. Portugal (upper chart in the figure below) seems to be going in exactly the exact same route in the bond markets as Greece (lower chart).  

Source: Bloomberg

Historically, the markets tend to pick out the weakest one by one rather than all at one go. Since most of us forget history (or believe we don’t need it) each time a company/country stumbles, we think it is a bolt from the blue. But it never is! 

The chart (above), calls into question the long-term efficacy of the current policy. Policy makers seem to think that given time, the issues will be resolved if the banks are able to “earn their way out of their problems”. This policy first propounded by Alan Greenspan immediately after the Savings and Loans Crisis in the USA, is bound to fail for the simple reason that the underlying structural problems need to be resolved quickly.  Richard Koo has shown why this failed in Japan. Infact, this already seems to be happening. In about a year from now, Portugal is likely to be in the same position as Greece finds itself today. Portugal and Greece are relatively tiny parts of the Eurozone. Once Portugal is picked out, the bond markets are likely to concentrate on Spain and Italy. This is not to claim that the policy makers are naive and have not realised the way the bond markets work. On the contrary, they are aware and that is why the recent attempts seem to attempt to ring-fence Spain and Italy rather than Portugal and Greece. 

The longer policy makers hold off from biting the bullet (writing off debt, regulating the derivatives markets, forbidding banks from trading and breaking up big banks) the greater the severity of the problem in the  near future.