The return of worries about the PIIGS weighs on the euro

Good news: Ireland isn’t Greece.

Bad news: Ireland isn’t Spain, either.

At least that’s what Standard & Poor’s concluded on August 25 when it cut the credit rating on Ireland’s sovereign debt one step to AA-.

S&P is worried that the cost of re-capitalizing Ireland’s banks is going to be higher than estimated. The company raised its estimate to $63 billion. That’s a more than 42% increase from S&P’s former estimate.

On the downgrade the spread on Ireland’s sovereign debt rose to a record 3.32 percentage points above the yield on the benchmark German 10-year bonds. In comparison the spread on Greek sovereign debt stood at 8.83 percentage points and the spread on Spanish debt stood at 1.83 percentage points.

Ireland had the largest budget deficit in the Euro Zone in 2009 at 14.3% of GDP. That’s projected to fall to 11.7% in 2010. Standard & Poor’s projects that Ireland’s net government debt will hit 113% of GDP in 2012.

Despite those high figures, Ireland gets a credit rating seven steps above Greece’s junk bond rating because the country’s economy is much closer than the Greek economy to returning to global competitiveness after the government imposed a draconian program of spending and wage cuts. And the Irish political environment looks like it will give the government more room to turn the country around in comparison to Greece.

On the other hand, the credit markets are drawing a big contrast between the lax pre-crisis regulation of the banking system in Ireland and the relatively solid regulation of Spanish banks. Spanish regulators had required banks there to increase their reserves as housing prices soared and that has limited the damage to the Spanish financial system.

The downgrade doesn’t come at a good time for Ireland or for the euro.

The country sold 400 million Euros to 600 million Euros in short-term debt on August 26.

And this is the third bit of bad news for the euro in the last week or so. First, Hungary has dug in its heels about making the budget cuts it promised in exchange for a European Union bailout. Second, Axel Weber, head of Germany’s Bundesbank, said that the European Central Bank will have to keep its emergency lending programs in effect longer than expected–until the first quarter of 2011. And now, third, Ireland’s downgrade reminds investors that while growth in the center of the Euro Zone (Germany and France) has been robust, the economies of the periphery remain troubled.

Euro (central bank) politics kill the euro rally–dead

If this is what a euro hawk is saying now, the European Central Bank will be in the emergency lending business well into 2011. That would match the U.S. Federal Reserve’s recent promise (most recently from Fed chairman Ben Bernanke today, August 27) to continue its policy of depressing long-term interest rates by buying Treasuries and mortgage-backed securities in the open market if the economy needs a boost.

The comments came on August 20 from Axel Weber, the head of the Bundesbank, Germany’s notoriously conservative No-inflation-at-any-cost central bank. Weber, a member of the European Central Bank’s governing council, said the ECB should help banks through the end of the year by continuing its current emergency lending policy.

I’d guess that might be the end of any chance for a euro rally against the U.S. dollar or yen in the rest of 2010. One reason the currency had climbed until recently was speculation that the European Central Bank would start to rein in the euro money supply before the U.S. Federal Reserve did. (And that, while still a long way off, the ECB would raise short-term interest rates before the Fed did in the United States.)

“It’s clear that we need to re-embark on a normalization procedure,” Weber said in tossing a bone to the inflation hawks, but any normalization will have to wait for consideration in the first quarter of 2011. The euro dropped and the yield on Germany’s 30-year bond fell to a record low on his comments.

Weber is one of the leading candidates to succeed European Central Bank president Jean-Claude Trichet in 2011. Opponents to his selection have argued that he’s too much in the mold of a Bundesbank inflation fighter and isn’t a good choice to guide euro monetary policy at a time when growth and jobs are the big issues. I read Weber’s comments as an effort to signal any wavering voters that he will be sufficiently flexible.

Hungarian budget goulash signals next phase in euro crisis

 Hungary’s budget crisis isn’t large in size in comparison to those of Greece or Spain, but Hungary’s crisis is a harbinger of the next crisis euro debt crisis.

Hungary’s budget crisis raises the question What happens when a country reaches a bailout agreement with the European Union and the IMF (International Monetary Fund) and then doesn’t live up to that agreement?

Narrowing down the list of Europe’s troubled banks

More details and better projections on the European bank stress test and what banks are likely to fail the test.

The smaller than expected demand—just $162 billion–for 3-month loans from the European Central Bank shows, I think, that the European banking sector is in better shape—as I whole—than feared. (For more on why this smaller draw is positive news see my post http://jubakpicks.com/2010/06/30/deja-whew-european-banks-dont-look-quite-so-troubled-this-morning/ )

But the fact that some banks felt the need to grab up roughly $140 billion in six-day money yesterday, July 1, shows that some banks are still having trouble raising money in the financial markets. Analysts estimate that roughly 170 banks in Europe (out of 1,100) are having trouble accessing the markets for capital.

Which banks are still shut out of the financial markets? A big chunk is likely to be Germany’s Landesbanks and Spain’s Cajas. (For more on Germany’s Landesbanks see my post http://jubakpicks.com/2010/07/01/germany-will-stress-test-its-most-troubled-banking-sector-by-mid-month-well-know-how-big-the-problem-at-the-landesbanks-is/ For more on Spain’s cajas see my post http://jubakpicks.com/2010/05/24/worry-over-shaky-euro-banks-pushes-up-interest-rates-threatening-the-global-economic-recovery/ )

And how big are the cash calls likely to be from the banks that fail the stress test?

Germany will stress test its most troubled banking sector–by mid-month we’ll know how big the problem at the Landesbanks is

At least we’ll know how bad it is.

That’s my reaction to news that Germany will extend its bank stress test to its Landesbanks. These banks, owned by the country’s state governments, are thought to be the most exposed to risky debt and the most undercapitalized of the country’s banks.

The original plan to stress test only the country’s biggest banks would have left the financial markets wondering how big the black hole in the Landesbank sector might be. But yesterday, June 30, regulators meeting with the Landesbanks and other German banks announced an agreement to extend the test to 16 banks, including an additional seven Landesbanks, covering about half of the market.

The consensus belief—maybe “hope” is a more appropriate word—is that the Landesbanks won’t need more money than the German bank rescue fund has available.