New Crisis Level for the Global Economy

U.S. Stocks Plunge: The interconnectedness of the global economy has never been clearer.  Trouble in Spain has sparked a global sell-off. U.S. Stocks plunged at the open Monday, 7/23/12 with widespread selling bringing the Dow down 200 points, on worries that Spain, the eurozone’s 4th largest economy may need a full-blown EU bailout.

Widespread Collateral Damage:In early trading the Dow Jones industrial average (INDU) sank 238 points, or 1.9%, the S&P 500 (SPX) dropped 29 points, or 1.8% and the Nasdaq (COMP) lost 71 points, or 2.4%.

Commodities also plunged, with oil and copper prices declining 3%.
The euro fell as low as $1.207.
Investors flocked to traditional safe havens, such as U.S. Treasuries, where the 10-year yield hit a fresh record low of $1.395%, while the German 10-year yield also fell to a record low of 1.127%.

The debt crisis plaguing Europe is seriously impacting Spain’s regional economies.  Valencia, for instance, requested emergency funding.

Bailout Highlights Eurozone Weakness

Eurozone finance ministers finalized initial bailout terms for Spanish banks, but observers fear that may not be enough.  Spain has already been granted a 100 billion euro (£80 billion) bailout for its banks, but has so far avoided following in the footsteps of Greece, Ireland and Portugal and taking EU assistance for the country. But the Valencia region on Friday said it would be the first to seek financial help from an 18 billion euro (£14 billion) fund set up to help the country’s regions. And Murcia’s government on Sunday said it was “studying whether to apply” for assistance.

Said Michael Hewson, market analyst at CMC Markets in London:

A Spanish sovereign bailout is inevitable. Just looking at the debt metrics, the lower GDP growth figures, and the bond yields across the board, it’s apparent that Spain will find it increasingly difficult to fund itself in the international bond market.

Unsustainable Yields: How bad is it? The yield on the 10-year Spanish bond jumped to a euro-area record high of 7.565% from 7.267%, even though Spain’s leaders have said that 7% is already an unsustainable level. Yields this high presage an additional Central Bank bailout.

Contracting Economy: The Bank of Spain also reported that the nation’s economy contracted by 0.4% in the second quarter,  the third quarterly contraction. Spain could be mired in recession for some time.

Economies Under Pressure: Stock markets in Spain and Italy were faring worst of all, with Madrid’s IBEX down 4% and Milan’s FTSE MIB 4.6% lower. Though Spain is at the forefront of concerns at the moment, investors are worried that Italy will be back in the spotlight soon. Its 10-year yield was up 0.28 percentage points to 6.35%.

A Perfect Storm

Meanwhile, a forecast from a Chinese central bank adviser that China’s economy could grow at a slower pace in the third quarter deepened concerns about the global slowdown.

A forecast from a Chinese central bank adviser that China’s economy could wane further in the third quarter also deepened concerns about the global slowdown. China’s economic growth slowed to a three-year low of 7.6% in the second quarter.

Asian Markets React: Japan’s Nikkei fell 1.9% to 8,508.32 and Hong Kong’s Hang Seng dived 3% to 19,053.47. China’s Shanghai Composite Index declined 1.3% to 2,141.40, while South Korea’s Kospi dropped 1.8% to 1,789.44.

What Will U.S. Quarterly Earnings Show? Investors are awaiting quarterly financial results from industry bellwethers around the world.  Later this week, UPS (UPSFortune 500), AT&T (TFortune 500), Ford (FFortune 500), Apple (AAPLFortune 500) and Amazon (AMZNFortune 500) are slated to open their books. Facebook (FB) is also set to report its first quarterly earnings as a public company.

While nearly all companies that have reported so far have topped earnings expectations, analysts’ forecasts were very low to begin with. In addition, just 45% of companies that have reported have topped revenue expectations, the lowest percentage since the first quarter of 2009, according to FactSet.

What went wrong with Spain?

Boom to Bust Scenario: Spain’s story illustrates the fact that the eurozone’s problems run far deeper than the issue of excessive borrowing by ill-disciplined governments. While Greece, Portugal and Italy all had considerable debt weighing them down, the Spanish government’s borrowing had been under control. In fact, it ran a balanced budget on average every year until the eve of the 2008 financial crisis. It’s radidly expanding economy prior to 2008 resulted in a falling debt-to-GDP ratio was falling, while Germany’s, by contrast, continued to rise.

Housing Bubble: When Spain joined the euro the Spanish government resisted the lure of cheap loans. However,  citizens and banks did not. The country experienced a long boom, underpinned by a housing bubble, as Spanish households took on bigger and bigger mortgages. House prices rose 44% from 2004 to 2008, at the tail end of a housing boom, according to ministry of housing data.

When The Bubble Burst: Since the bubble burst, housing prices have tumbled by 25%. The economy, which grew 3.7% per year on average from 1999 to 2007, has shrunk at an annual rate of 1% since then.

In response, the Spanish government, which still had relatively low debts, it is now forced to borrow like crazy to deal with the effects of the property collapse, the recession and the worst unemployment rate in the eurozone.

What is the Problem with the Banks? In short, high-living in the boom years led to an uncomfortable return to reality. Before the credit crunch, the banks had been thriving thanks to the rapid expansion of the property sector.

But the housing collapse resulted in defaults from borrowers and a plunge in the value of the assets the loans were based on. Since the onset of the recession, which is expected to continue throughout this year and next, losses on loans have continued to mount as borrowers struggle to make repayments.

The situation was made worse by the fact that the banks borrowed the money on the international markets to lend to developers and homebuyers, a riskier strategy than using the deposits they get from savers.

They are now sitting on massive losses whose size is not yet fully known – some say it could be as much as 180bn euros. Fortunately, not all banks are in this situation, and the International Monetary Fund said a large part of the banking sector, including Santander and BBVA, is well run and resilient.

What Has Been Done to Help Troubled Banks? Spain has begun to restructure its banking sector, and many of its smaller, weaker banks have had to merge or have been rescued by larger ones. The number of branches has been cut by 15%, and 11% of the jobs in the industry have gone.

Up to the end of April, the government had injected 34bn euros into its banks, not including the 19bn euros Bankia, Spain’s fourth-largest bank, asked for shortly before it was nationalised. Bankia itself was formed when several regional banks, or cajas, were brought together because they were too small to bear the knock from the economic downturn.

Balooning Confidence Crisis: The crisis of confidence in the markets about the state of the banking sector and its impact on government finances has made it increasingly expensive for the government to borrow on the markets since investors demand higher interest for riskier prospects. As a result, Spain has had to turn to emergency funding from its eurozone partners.

How will the bank bailout work? Spain will be able to borrow up to 100bn euros. The help it gets will differ from the bailouts given to Greece, Portugal and Ireland in several ways.

First, the loans will come from eurozone funds set up to help members in financial distress: the European Financial Stability Facility and/or the European Stability Mechanism, whereas in previous cases, money has come from  the European Union and the International Monetary Fund as well as the eurozone.

Second, the money will be targeted specifically at Spain’s banks, rather than at the economy as a whole through central government.

The Catch – Austerity Measures: Spain was desperate to avoid this, as the sovereign bailouts have previously come with demands to cut spending and raise taxes and close supervision of the countries’ finances. Prime Minister Mariano Rajoy has unveiled another set of austerity measures, including another 65bn euros of spending cuts and a rise in VAT from 18% to 21%.

As a result, at the meeting of eurozone finance ministers on 9 July, it was agreed that Spain could borrow an initial 30bn euros to support its banks. The final figure of how much of the 100bn euros offered that Spain will want to borrow may not be known until September.

Takeaways

Sudden Plunge into Debt: The economic numbers for Spain are not as horrendous as those of Greece. However, the Spanish banking system is loaded with real estate debts that will never be repaid, making Spanish banks a default waiting to happen. Meanwhile, the country has horrific unemployment of over 20% while over 12% of the working population are civil servants.

Nearsighted Economics: Leading up to the crisis, the country had in effect been financing itself from a runaway property boom. This is a key European trick to pump huge taxation flows into government coffers and make the population feel rich and happy, boosting short-term business. In the end however, like all credit bubbles, it has to implode.

Bubble Based on Consumption, Not Industry: During the property boom, the country feels rich and has cheap credit as citizens buy goods. But because the country has not made the money by industry, imports are the only way to quench the credit-fuelled thirst. Import levels explode and create a giant trade imbalance  – 10% of GDP at the height of their boom.

So rather than get rich from a property boom, the new money flows abroad to the goods producing developing world, leaving the beneficiaries of the property boom in debt.

Shortsighted Government Policies for Political Gain: The short-term windfall of a property boom also supports restrictive labour policies, making local industry almost impossible to grow. Who would create industrial jobs which can’t be sustained?

In a boom with little real growth,  governments use tax revenues to bloat the public sector, building tramways, sculptures and roads. Public sector jobs explode, and civil servants get better conditions (in Spain’s case yet shorter “working” hours.)

GDP appears to grow because GDP contains government spending growth, but, again, the productive part hasn’t grown. For all the boom-time money, real sustainable economic growth remains dormant.

When the property bubble bursts, tax income collapses, government deficits explode, banks over-burdened with bad property loans collapse. Government debt is hard to finance, and interest rates rise.

European Central Bank to the Rescue: If a country’s banks become shaky, the European Central Bank (ECB) buys their bonds – which they can invent by swapping with other ‘dodgy’ banks. In exchange, banks buy government bonds to fund the deficits of their country, on the back of the credit worthiness of the whole of Europe. This creditworthiness is in effect underwritten by the credit-worthiness of sounder, less leveraged European countries like Germany, Holland and France.

In effect the ECB and Europe is trying to act as if it is the U.S. Federal Government – ‘the United States of Europe’, even though the treaties are not in place to do so.

Can They Pull It Off? Spain highlights the key question of whether Europe haw the will and ability to continue this process and bail out Spain, and then Italy.  This will require a major European monetary shift, involving broad inflation as the ECB will have to re-inflate to rebase the economies of Europe into some kind of equilibrium. If the ECB pulls this off smoothly, the euro crisis will really be put to rest.

However, a re-run of last year’s chaos, will drag the crisis beyond 2012 into 2013 and 2014. If the euro dam breaks then the economic consequences will be an economic tidal wave.

What to Watch: There are two main dials to watch. The yen and the strength of the euro. A strong yen generally means people are running from something scary. Yen rallies mean fear is in the market – most likely Euro-based.

The stronger the euro, the more likely something bad will happen to European monetary union. In any euro emergency it is the weaker countries that would be expelled, strengthening the euro. If the weak countries leave to escape back to their old currencies, the Euro will rise. If they stay, there will be a lot more money printing in Europe and the euro will weaken.

A yen and euro rally would be a bad omen for Europe, while a falling euro and yen would mean the euro storm is passing.

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