If running out of
your own money wasn’t bad enough, policy makers are increasingly spending
other peoples’ money to bail their country out. At the upcoming G-20 meeting, finance ministers from around the world will
contemplate an increase to the resources of the International Monetary Fund
(IMF). At stake for politicians is whether they can continue to do what they
know best – to play politics. In contrast, at stake for investors may
be whether currencies will retain their function as a store of value.
Let’s highlight Spain, as the country may be
the key to understanding how dynamics may play out. Last November, Spaniards
voted for change by electing conservative Prime Minister Rajoy,
handing him an absolute majority in parliament, displacing the previous,
socialist government. The election may cause former British Prime Minister
Thatcher to change her view, that socialism is
doomed to fail, as ultimately you run out of other people’s money. It
doesn’t take a socialist to run out of money. In the case of Spain, if
you run out of your own people’s money, there may always be other
One of the major concerns is Spain's regional
government debt. Spain consists of 17 autonomous regions, whose total debt
almost doubled in the past three years, due to economic recession and a
housing market collapse. In many ways, Spain reflects a microcosm of how the
Eurozone as a whole is structured:
- Spanish regions
have the power to issue public debt. The central government has little
ability to interfere with regional government spending and is prohibited
by Spanish law to bailout regional governments.
- While regions
enjoy high autonomy on spending, the central government retains
effective control over regional government revenue.
- Spain has its
own peripheral problems: the most indebted region, Catalonia, recorded
20.7% debt-to-regional-GDP ratio and 3.6% deficit-to-GDP ratio in 2011.
Its 10-year bond yield recently breached 10%, far beyond the yield on
10-year Spanish government bonds, which yield around 6%. In 2011, the
total debt of 17 regional governments rose to €140 billion,
accounting for 13.1% of Spain's GDP. This number is up from 6.7% by 2008.
- Spanish law
forbids the central government from rescuing regional governments (in
much the same way that the Maastricht Treaty prohibits bailouts of EU
countries). In practice, the central government appears to have
implicitly helped Valencia, Spain’s 2nd most indebted region, with
a €123 million loan repayment to Deutsche Bank.
More broadly known are Spain’s banking woes.
Unlike much of Europe, a housing boom propelled much of Spain’s recent
growth, causing Spain’s regional banks, in particular, to become overly
exposed to the mortgage sector. Spain’s banks are very dependent on
liquidity provided by the European Central Bank (ECB). The recent 3 year
long-term refinancing operation (LTRO) by the ECB at first took pressure of
the Spanish banking system, but has since been seen more critically, as
Spain’s banks may be using the liquidity to buy Spanish government
debt, thus increasing inter-dependency and potentially making nationalization
of Spanish banks (read: the Spanish government taking on the obligations of
its banks) more, rather than less likely.
The tensions between Spanish regions and its
national government are nothing new. And that’s really the main lesson
here: it’s business as usual in Spain! As of
late, Rajoy’s government appears to be
reining in regional control over budgets in earnest. However, Spaniards are
used to eternal debates on where subsidies should come from, how to stop
regions from spending, and – conversely - how to find ways around
restrictions. In brief, Spaniards are pros at this battle. Not surprisingly,
when there’s a threat of market headwinds, Rajoy
is publicly committing to reform. The moment the pressure abates, it appears
those promises are forgotten. Spain is proof that the only language policy
makers may be listening to is that of the bond market.
As painful as it is, volatile markets are necessary
to keep policy makers focused. Whenever Spanish bonds come under pressure,
Spain moves further from talk and closer to action, with respect to
implementation of more austerity measures, as well as the pursuit of
structural reforms. Spain – like so many developed countries –
has rigid bureaucracies aimed at protecting the old (companies and employees)
at the cost of preventing the new, stifling innovation and fostering massive
youth unemployment. Structural reform is politically painful. What is
striking about Spain is that it has an enviable position of a government with
an absolute majority. Yet, even such a seemingly strong government is
dragging its feet in implementing reform. In the process, political support
is eroding, thus making it increasingly difficult to pursue reforms as the
economic environment worsens.
Politicians always appear to consider the cost of
acting versus the cost of inaction. As long as more money is lined up: be
that from the central government for the regions; be that from a European
stability fund for the government; or be it from the IMF, incentives for
reforms are taken away. In many ways, Catalonia should be getting the message
that its budget is unsustainable, but with help on the way from Madrid, the
region may continue its bad habits.
As Europeans have convinced themselves that they
have done plenty of the heavy lifting, the next stop is the IMF, where member
countries are expected to pledge billions more. The critics may be forgiven
for pointing out that Europe could be doing more before tapping into purses
of other, less affluent countries. Unfortunately, politicians treat this as
politics rather than a serious debate about money. The good news here may be
that we don’t think this is a European problem. The bad news is that
this is a global problem. Spain is not unique. In the U.S., we have many of
the same challenges, but we have a bond market that has allowed policy makers
to get away with spending ever more money. Different from the Eurozone, the
U.S. has a significant current account
deficit. As such, should the
bond market impose austerity on U.S. policy makers, it may have far more
negative implications on the U.S. dollar than it has had on the Euro to date.
In the meantime, as policy makers around the world
continue to hope for the best, but plan for the worst, expect monetary policy
to be most accommodating: the U.S., Eurozone, UK and Japan all have eased in
some form or another in recent months. Beneficiaries in the medium term may
be precious metals and commodity currencies. For now, those currencies have
been held back by a generally somber mood about global growth. What has done
well – and we expect will continue to do well – are the
currencies of countries that realize such policies will foster inflationary
pressures. Singapore should be praised in this context, as the Singapore
Monetary Authority tightened monetary policy last week, allowing the
Singapore Dollar to appreciate. Those countries that can afford to are taking
note that all this easy money may have significant side effects and are
taking action to combat it. However, such countries are few and far between.
We have long argued that there may not be such a thing anymore as a safe
asset and investors may want to take a diversified approach to something as
mundane as cash.