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Is the ECB Making a Mistake on Rates?

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The European Central Bank Thursday began raising rates -- to 1.25%, up a quarter point -- despite a weak Eurozone economy and Portugal’s need for a bailout, a bailout that breaches the zone’s “no-bailout” clause.

The ECB has been spooked by some signs of inflation, largely fueled by volatile oil prices. But, in raising rates, it is touching off unintended consequences -- including exacerbating member states' debt problems that can be helped by cheaper exports and lower interest rates.

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Yes, raising interest rates makes the Euro more attractive to currency investors, which is why the Euro has been strengthening against the dollar, up 8% so far this year and 24% over the last decade. Yes, quantitative easing has weakened the dollar (on purpose, to make U.S. exports cheap), but the Euro is strengthening against other currencies.

And that strengthening Euro makes the value of the Eurozone’s exports more costly. It makes borrowing costs for exporters more costly. Already, Moody’s Investors Service says it is zeroing in on Portugal’s weak export sector as part of its credit rating review. Making Portugal’s exports more expensive may worsen the country’s sluggish economic growth.

The rate hike may also put at risk the borrowing costs for the economies of the Eurozone member countries, particularly the PIIGS (Portugal, Italy, Ireland, Greece and Spain), which may need to go hat in hand for bailouts, notes FOX Business news director Ray Hennessey.

The rescue pricetag could go up if higher interest rates hurt the PIIGS, who need to grow their way out of their debt crises. It also hurts mortgage borrowers, notably adjustable rate holders whose loan rates will rise.

However, the ECB has reacted to growing inflation in the Eurozone with a rate hike, inflation which has risen above its 2% target to 2.6%, primarily due to higher energy costs.

Meanwhile, wages remain somewhat moribund in the Eurozone as unemployment is as high as 20% in a number of member states, including Spain. Wages overall are increasing at just about 1.4% year to year. Eurozone workers get pay raises linked to inflation, so that is a concern.

The Two Blades of the Scissors

Meanwhile, the U.S. is dragging its feet on its record $14 trillion federal deficit. It used to be that one blade of the scissors was the debt ceiling, the other a potential downgrade of the U.S.'s Triple-A rating, held since 1917, which the credit rating agencies have  increasingly warned could happen.

But the Democrats and the White House are ignoring both of these looming threats.

Eleven times since 1995, the U.S. has raised its debt ceiling. Fourteen times since then, the Government Accountability Office could not sign off on the U.S.’s books because they are in such disarray.

Higher rates for both the U.S. and Europe are on the way, Wall Street analysts note, and that could hurt government borrowing costs which already face potentially higher yields due to a bond glut -- a classic supply-demand issue.

James Reid, a top bond market strategist at Deutsche Bank (NYSE:DB), notes that government debt in the U.S. and Europe is the final link of the “chain in the rolling supercycle of bubbles.”

Moody’s Investors Services notes that governments are the biggest borrowers in the capital market, issuing more than $8 trillion in debt, or two-thirds of the total, in 2009, the latest data available.

As those bubbles blow, credit rating agency downgrades have poured in, as in Japan, Portugal, Spain and Greece. Moody’s downgraded Greece a whopping nine notches in just a little over a year and two months time, notes Gary Jenkins of Evolution Securities.

U.S. Helping Europe, Once Again

The U.S. is already helping bail out some countries like Greece via its funding of the International Monetary Fund, which acts like a global credit facility whose members fork over money that the IMF board deigns to mete out.

The U.S. is the IMF’s largest shareholder at 17.09%, followed by Japan’s 6.12% and  Germany’s 5.98% -- France and Britain are around 4.94% each.

The way it works is, the IMF borrows from the U.S. central bank at a quarter of a percentage point rate, then charges the PIIGS 3% on their loans. The IMF then absorbs any losses on its loans.

Question: Why doesn’t the Fed charge more? Given that reports indicate that Portugal and Greece are habitual defaulters, each having done so five times since 1800. Spain defaulted seven times?

Moreover, the stronger nations’ share of the IMF pot is actually heavier, because not all of the IMF’s shareholders have strong enough currencies that debtor countries even want. (Would you want the multi-trillion dollar currency of Zimbabwe?)

So, the U.S., Japan and European countries like Germany end up backing a bigger slug of IMF funding.

Totting up all of the IMF’s drawdowns, the 17 countries in the Euro-zone may have to shoulder a bigger part of the IMF’s PIIG bailouts versus the U.S. That’s separate from the Eurozone’s giant bailout facility, now at $1 trillion.

Dangerous to Let Bond Market Enact Fiscal Austerity

Of course, the success of any bailout depends on the debtor nation toeing the line to cut back government spending, including public sector pay. Portugal finally adopted an austerity budget after nixing tougher plans three times.

It only did so after the bond market punished Portugal’s apathy by spiking its five-year bonds to 8.6% and 9.7% on its ten year bonds, causing its borrowing costs to rise even higher. Bond yields for Ireland and Greece are stuck at double digits for both.

No country should wait for the bond market to enact its fiscal austerity for it.

The bond market is already a financial pressure cooker, nerves in the market are shredded, and yield spikes higher can be swift, brutal and overnight. Is Washington, DC listening?

On top of its borrowing, Portugal may need a bailout of $129 billion dollars, the country’s business daily Diario Economico is quoting government sources as saying. That is more than half its GDP, Diario Economico said.

A Better Weathervane

Meanwhile, the credit default swap market is a better weathervane than credit rating agencies and even the bond market as to the osteoporosis in a government’s weakening fiscal balances blown out by derelict spending. CDSs started flashing trouble for the PIIGs two years before Greece debt crisis last May, when $5 trillion in market value was wiped out, hastened by the flash crash. CDS spreads are starting to signal trouble for the US now.

Euro Rides the Back of Germany’s Triple-A

The experiment of imposing one currency, the Euro, upon multitudinous economies has clearly derailed. The Euro was always a rickety construct ever since Germany started hollering it didn’t want to join the Euro--and Great Britain successfully fought inclusion--when the Maastricht Treaty launched the common currency in 1992.

The Euro is not backed by any full political and fiscal union in the form of one government, one Treasury, or one tax collector.

Instead, the Euro has ridden on the back of Germany’s Triple-A rating for nearly two decades now.

The problem is, the ECB regarded as equal the 17-member Euro nations’ sovereign debt, as if Greece were as risk-free as Germany, Portugal as risk-free as France. The ECB accepted all of their debt as collateral at its discount window on the same terms.

Wrongfully Blaming the U.S. for Europe’s Housing Bubbles

In turn, the high yield tourists that are now the banks also generally regarded the 17 countries' debt as the same, and piled on their books the sovereign debt of these feeble Euro countries. For that risk, they grabbed several extra basis points in yield, increasing their bottom lines a bit more.Because Greece’s debt was considered Triple-A, the banks got away with carrying these “riskless” assets on their balance sheets with less capital cushion then necessary.

And because the banks were buying their debt, that kept the PIIGs’ borrowing rates low, it kept their consumer borrowing rates low, and lo and behold, Spain, Ireland, Portugal, all saw massive housing bubbles that were home-grown—even though media pundits here in the US blame US [policy for Europe’s housing problems.

Just Like Latin America’s Debt Crisis

To rescue themselves, the 17 countries of the Eurozone have already launched a newfangled Euro-bond, or E-bond, which could ease the distress of the zone’s banking system.

The E- bond, now in tiny allotments, is issued by the Eurozone’s $1 trillion bailout fund and backed by the full faith and credit of the 17 Euro nations.

That could lay the foundation for a better, more integrated European bond market which would take the stress off of the U.S. government, where the Federal Reserve have been used by European governments to hold their central-bank reserves and to alleviate market distress via trades like foreign currency swaps.

The way it works is, each member country could borrow up to 40% of its GDP at dirt-cheap borrowing rates, because the theory is the E-bond would be rated Triple-A.

To get that rating, though, the zone’s strongest countries—Germany, France--would have to guarantee the lamer countries’ debt—the PIIGS. If member countries wanted to borrow above 40% of GDP, they would have to issue their own bonds at likely higher interest rates.

However, German Chancellor Angela Merkel has been opposed, worried about moral hazards. Chancellor Merkel has said that: “We must not make the mistake of thinking that collectivizing risk is the answer.”

E-Bonds Echo U.S. Brady Bonds

The E- bond echoes the U.S. Brady Bonds launched in 1989, named after then U.S. Treasury Secretary Nicholas Brady, to help put an end to the lingering Latin American debt crisis that began in 1982.

The bonds let these defaulted countries swap out their creditors’ bad government bonds for better, new guaranteed debt securities or Brady bonds.

The 1982 Latin America’s debt crisis had morphed into a banking crisis, which then New York Federal Reserve official Richard Koo, now at Nomura Securities, has said was worse than the banking crisis the U.S. just endured. Back then, Citigroup got the first of its eventual three bailouts.

The Way It Worked

The answer was to have international lenders loan insolvent countries in Latin America money to service their debts and give them time to restructure, and so that the banks could plow money back into their capital cushions. The countries borrowed commercial loans from the banks, then issued new government bonds to their creditors.

Because their new issuances were collateralized by U.S. zero coupon bonds, they became tradable. Commercial bank creditors then forgave 30% of the debt in question in exchange for these collateralized, floating-rate bonds.

Mexico, for instance, backed their Aztec bonds by purchasing a 20-year zero-coupon US Treasury bond to be deposited with the US Federal Reserve until maturity.

Later, U.S. Treasury Secretary Nicholas Brady in March 1989 launched the Brady Bond program, a voluntary restructuring of defaulted debt.

The Brady Plan called for the United States, the IMF, the World Bank and central banks in Latin America to loan distressed countries money so they could convert their defaulted loans into bonds, or “Brady Bonds,” backed by U.S. zero-coupon Treasury bonds as collateral.

Because Brady bonds were backed by U.S. zero-coupon bonds, principal repayments were guaranteed, making them more easily tradable.

That in turn helped the countries and their banks flush out the bad debt on their books.

Ironically, just like the 17 nation Eurozone, 17 countries, including one in Africa, one in the Mideast, and two in Asia, had restructured via the Brady bond program by July 1999: Albania, Argentina, Brazil, Bulgaria, Costa Rica, Dominican Republic, Ecuador, Jordan, Mexico, Nigeria, Panama, Peru, Philippines, Poland, Uruguay, Venezuela, and Vietnam.

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