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To default or not to default – that is the question.

As the markets focus once again on Greece’s ability to repay its debt, last month’s pop up in both Spanish and Italian yields caught the markets by surprise and posed the question –“Could Spain be the next bailout candidate?”

Spain has always been the canary in the coalmine and if it ever sought a bailout no type of rescue package would be big enough to save it – and if we did reach this stage then it’s highly likely the euro would simply have no further value as a currency.

Spain is fairly unique as it’s governed by 17 autonomous communities alongside a decentralized government. Each one of these has its own budget and the markets concern is that central government still does not have a true handle on the debt exposure of these 17 communities. The “hidden debt” problem first popped up in Catalonia after elections last autumn resulted in Catalan nationalists unseating a Socialist-led coalition. In December, the central finance ministry said the region’s debt-to-regional-GDP ratio was 1.7% as of the third quarter. The old government later disclosed the full-year deficit could be as high as 3.3%.

Last month’s Spanish elections saw more socialist regional governments voted out of office and the real fear that more hidden debts could emerge. Spain has made great efforts in cutting its deficit to 9.3% of GDP, however much of this has come from centralized government cuts.

The huge glut of unsold homes and the billions in bad property loans still lie on the balance sheets of mainly provincial banks that have yet to still fully disclose their liabilities. Spain certainly has a challenge ahead of it and with youth unemployment the highest in Europe at 44% it’s clear that it has a generation that will have to make tough sacrifices and decisions.
Greece remains the problem that just won’t go away. If life was simple Greece should take a haircut on 50% of its debt obligations and look to rebuild. However the risk of contagion would be far too great and this would spread to Portugal, Ireland, and even Spain. German banks would be forced to write off billions of euros and it would send the global economy back to the dark ages.

The solution the euro politicians have come up with is the term debt reprofiling. Put simply it would allow a country to roll over its debt obligations for a period of maybe 35 years. This would get round a technical default, that itself could trigger a wave of CDO claims as debt insurance would be triggered. As with anything in European politics nothing has yet to be decided but it’s clear the indebted southern nations can no longer devalue their currency, do not possess anything like the levels of growth needed to repay their debt and have reached levels of austerity that are no longer effective.

Sterling will remain under pressure as the UK economy looks like its hitting some turbulence as the consumer responds to the government’s tough austerity measures. It’s highly unlikely the Bank of England will hike rates in 2011 and the pound along with the dollar and euro will still be viewed as the 3 ugly sisters by the currency markets.

Keith Spitalnick LLB (Hons)

Regional Sales Manager

Currencies Direct

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Thought 2010 was tough?

Well if you thought 2010 was a tough year, 2011 will probably bring much the same for the currency markets, with volatility certain to be an ongoing theme.

Looking back at 2010, until the Eurozone debt crisis reignited at the start of October, Sterling had been rapidly losing ground to a dominant Euro. In September, when the Bank of England began to make noises about firing up the printing presses again with more quantitative easing, Sterling dropped back from just below €1.24 to levels as low as €1.12.

But a late showing of stronger data for the UK economy, (which quashed the threat of more quantitative easing for now), the Ireland bailout and the fear of Eurozone ‘contagion’ saw the pound recover to its current level, after briefly popping its head above the €1.19 parapet.

UK inflation remains high

To predict the direction of Sterling is a tricky call to make. Despite the UK economy struggling and unemployment levels starting to rise, inflation in the UK remains above the Bank of England target of 1-3% and is likely to increase even further in 2011. Whether inflation rises or falls is crucial for sterling, because if it remains around the 3% mark in the medium term, pressure will mount on the Bank to raise rates.

Call for interest rate hike

We have already seen one member of the Bank of England Monetary Policy Committee, Andrew Sentence, calling for an interest rate hike and the growing belief that when rates do rise in the UK they will go up very quickly which will have a positive effect on Sterling, possibly pushing it as high as 1.25-1.30 against the Euro. However any rate increase will probably not come until late 2011, so until then, the value of the pound will remain fairly range bound against currencies like the Euro.

Challenges for the Euro

The challenges facing the Euro in 2011 will be much the same as in 2010 – the need to service the debt of the southern European states. Italy, Spain and Portugal have to finance in excess of €800 billion of new and existing debt and should they find the market has no further appetite then the Euro could really start to fall apart.

China could come to the rescue of the Euro, as they certainly do not need their biggest trading partner imploding, and the Chinese are also keen to move away from having a huge dependency on the value of the US dollar.

So I am very intrigued as to the direction of the Euro over the next 12 months. The US dollar could be the surprise package in 2011 as growth rates for the US economy are upgraded, but once again this will probably not occur until late 2011.

Looking for certainty?

So if you’re looking for certainty, the only thing we can really be sure of is that volatility will once again be the key driver in 2011.

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