Are Financial Markets in the Calm before the Storm?

With the announcement of a bailout package for Spain in the vicinity of $125 billion over the weekend, authorities in Europe hoped it will help to buy more time with the aid of an engineered rebound in the stock markets. However, the so called rebound is short lived and it fizzles out after a couple of hours of trading as investors viewed the bailout package as another ‘Band Aid’ solution to the problem.

The Spanish IBEX was up by about 5.6% at one time and when the euphoria fizzles out, it closed down -0.54%, Italian market was also down 2.74%, FTSE which was up by 100 points also closed down 2.74 points. So why the $125 billion bailout package only managed to buy 2 hours of relief? We believe the following might be the reasons.

1. The actual problem of the crisis is not addressed. Europe is facing a credit crunch and you can’t solve a Sovereign Debt Crisis by pumping more liquidity into the system. It will only provide a temporary relief to the problem and hence buy more time. People are getting nervous as policies after policies dished out by the authorities doesn’t seem to work. After two years down the road, when Greece got its first bailout money, its problem seems to get worse. Subsequent bailouts don’t seem to have any more effect on the Greek economy. People wants to see more solid restructuring and brutal austerity measure like how the IMF imposed on some Asian countries during the Asian Financial Crisis in 1998. In short there are not even a single Eurozone countries are serious about practicing real austerity. Another funny thing is that the current bailout package for Spain does not come with any austerity measures and hence it will lead to Ireland, Portugal and Greece demanding for a renegotiation on the term of their bailout packages.
2. Due to the inability of the ECB to solve the crisis, it led to a loss of confidence among the citizens in the Eurozone. There have been reported bank runs in Greece and Spain. Instead of keeping money in the bank Greek citizens are withdrawing money from banks and keep it at home and saying that it is ‘safer than putting it in the banks’. Due to the upcoming of the Greek elections on June 17, according to a Bloomberg report ‘deposits are leaving the banks at the rate of about 100 to 500 million Euros a day’ because there is a panic in the street that if Greece were to exit Eurozone then there will be a devaluation in the drachma. Spain is not much better when Spanish depositors withdraw more the 65 billion Euros in March alone from its banking system. Due to its unregulated banking system during the booming years, more than 50% of its loans are given out to unqualified borrowers also known as sub-prime in the US.
3. The contagion has spread to Cyprus. Spain’s bailout actually sets a precedent for future bailouts in the Eurozone. Cyprus after seeing Spain’s bailout without any austerity measures also make known its intention to be the fifth nation in the Eurozone to receive a bailout. It is reported that Cyprus are already taking the necessary steps for making an application for a bailout before it takes over the European Union presidency in July. Due to the mark down of the value of its Greek bond holdings, two of Cyprus biggest lenders namely Bank of Cyprus and Cyprus Popular Bank needs more fund to recapitalize its position. Moreover the biggest fear will be Italy which is already ‘at the edge’. Italy which is the third largest economy in the Eurozone, is reportedly close to being requesting for a bailout. Austrian Finance Minister Maria Fekter said on Monday that ‘Italy may have to work its way out of the economic dilemma of very high deficits and debts and it too may need support’. The following is the Pie Chart of the GDP distribution of the Eurozone countries.

4. Eurozone Bond yields are hitting highs. After Merkel’s comment on delaying the possibility of issuing Eurobonds, Spanish 10 year Bond yields sky rocketed to an ERA High of more than 6.8% and meanwhile Italy’s 10 year Bond yield also climbed to 6.22%. This is because investors also concerned that the bailout package might lead to a full scale international bailout in the near future. Despite several tranches of funds injected into the Greek economy, it effects seems vaporized. Investors also feared that Spain might follow the footsteps of Greece where multiple tranches of funds will be needed in the near future.
5. There are concerns about where is the bailout money coming from. Will it be coming from the IMF or the going to be establish ESM? There are also worries that the reserve funds in IMF which only totaled $440 billion will not be sufficient to accommodate Spain's $1.5 trillion economy in the future. According to JPMorgan Spain will eventually need between $350-$450 billion for a full bailout. Since the nature of this bailout is a banking bailout and not a sovereign bailout, its fund will be used specifically for the banking sector and the public at large will not be able to benefit from it. 

In conclusion, we foresee there are no known solutions to the Eurozone Sovereign Debt problems in sight. Bailing out is not a solution to the problem but only provide temporary relief to calm markets. Until there are efforts by Eurozone countries to really impose austerity measures as proposed by the IMF and ECB, the problem will not somehow be solved. Nobody is making any effort to ‘Balance their Budget, letting weaker countries to go bankrupt, raising interest rates to flush out weaker economies’ or in other words, nobody is serious about doing anything to help contain the crisis.

In fact what we are seeing in the near future will be more countries joining the bailout bandwagon. In fact we believe that the Financial Markets are now in the calm before the storm. Things will get ugly when larger economies like Italy and France will be the next dominoes to fall. Then there will be panic in the financial markets. Will the next be Cyprus and then Italy and then Belgium, and then France and then Germany?