A week is a long time in politics, it’s even longer in economics. A week ago, before the 100 billion euro bailout package for Spanish banks, 10-year bond yields were as high as 6.84%—by way of comparison, Germany’s bond yields, also rising as the European contagion fear rises, are still at 1.5%. Today, with the markets realising the deal may not mean much as the resultant hike in Spanish debt may just force Spain out of bond markets and force it to borrow from its banks, 10-year yields are 6.93%, even higher than they were before the 100 billion euro package. In Italy, which is seen as the next country likely to need a bailout, the government sold 1-year bonds a few days ago and paid double of what it paid for such bonds just a month ago; 3-year bonds, also sold a few days ago, have been raised at 5.3% versus 3.9% just a month ago. With inflation at 2%, this means the government is paying a real interest of 5% and with GDP likely to contract this year, this means Spain’s debt-to-GDP ratio will continue to rise. Spanish debt, as a result of this, has risen from 61.2% of GDP in 2010 to 68.5% in 2011, that of Italy from 118.6% to 120.1% and Greece from 145% to 165.3%.
Given how a Greek exit from the euro will mean immediate banking chaos—part of the controls planned are transaction limits to ATM withdrawals—in both Greece as well as some of the other troubled nations, all attention is focused on the Greek exit (Grexit); more so since the outcome of Sunday’s elections, the second in six weeks, will indicate which way Greece is headed. But even more traumatic is the possibility of a Spanish panic (Spanic) and an Italian tanking (Itank), especially given the way Spain has just been downgraded to a tad above junk grade—Spain’s economy is 5-times Greece’s and Italy’s 8 times. In the case of Spain which has 734 billion euro of debt, a junk status would also play havoc with bondholders who, by law, are obligated to hold only investment-grade paper—when it cut Spain’s ratings 3 notches, Moody’s has said it could do this in the next 3 months. According to an IMF projection in April, European governments and their banks need to refinance an amount equalling 23% of their GDP in 2012 itself—with Spanic and Itank gaining momentum, this amount could rapidly rise.
Various rescue proposals are doing the rounds, from a European banking union where the deposits of each country’s banks are guaranteed by the European Central Bank to red and blue Eurobonds—blue bonds are guaranteed by all eurozone countries and countries can issue bonds worth up to 60% of their GDP; anything above this will be raised by red bonds guaranteed only by the issuing country. At the end of the day, however, there is no shying away from deeply unpopular reforms and, in the short-run, Germany needs to play the lender of the last resort.