Weeks ago when the EU debt crisis had started spreading, I had relatively tense arguments with my investing partner about the power of government(s) in coping with challenging situations in time of crisis. The traditional stand point holds the power of governments in settling things under political power – including various sources of influences such as geopolitical positions and relationships, national defense, soft power, regulations, legal framework, fiscal policies, etc. I’m not going to deny any part of this wide-affected tradition; like it or not, politics and all of its friends are what shaping our life day by day. Yet, I’m going to recognize another source of global power that is not only shaping our life day by day but also challenging the political power that traditionally rules the world: the pressure from the financial markets.
There are many ways to see the world. Most of us see the world as a stage for various countries to come, show, and go. Think about history, it is full of political events. Let’s begin with the ancient civilizations of Chinese, Egypt, Babylon, Greece, Roman,… then continue to the feudal age around 9th and 10th century with Briton, Frank, Celts, Vikings, Goths, Teutons, etc. China was mostly a mystery with some limited global striking events of Attila the Huns and Genghis Khan. India was also another mystery through stories from Silk Road. Latin America with Aztec, Inca, and Maya was absolutely untouched. Then 15th century started by Portugal and Spain who conquered the world and discovered America, China, and India. 16th and 17th century followed by England and France who came and shown with a series of invasions to the rest of the world – “The sun never set in British empire”. 18th century ended with the independence of America from England. 19th century marked Napoleon journey in the first 20 years, then the rise of young America and civil war in the later part. 20th century came with German’s power, World War I, World War II, and Cold War between Soviet Union and America as the only two super power nations. England, France, Portugal, and Spain once dominated the world then went to the past, just like Babylon, Egypt, and Roman empire. At least, this is the way I see the world in the past. Now I see it a little bit different – I see it as a stage for global forces to come, show, and go. The global forces might be countries, however, they open for other forces, much younger and not so less powerful: technology, financial markets, environment, religion, humanity, and much more hidden forces that might come in the future: energy, biochemistry, or demographic structure.
Among these “new” global forces – financial markets seem standing out and threatening to anyone who ignores its existence. I wonder how long this force has come and shown. I can taste it pretty clear now – during the current EU debt crisis. I can trace it back to Asia financial crisis in 1997. I’m thinking about the gold mass sell off of US and UK in 1968 before Bretton Wood ended in 1971 but the clue was far blur. Oil shock in 1970 should be more politic than economic. Panic of 1907, crash of 1929, Black Monday of 1987, and dot com bubble in 2001 were so US domestic so I won’t count them. There is a speculative attack to Sterling Pound led by Soros in 1992 may be counted.
In a simple form, punishment from financial markets to a country is the distrust of that country. This distrust is led by a lost of confidence. Governments, in a sense, are just like companies. They have board of directors led by a prime minister or president, they have sources of incomes and expenses, they borrow money short-term and long-term to run their business, as well as they also lend their money out or invest to earn interests. When governments want to borrow money, they go to financial markets and issue sovereign bonds – with duration and interest. When time comes, they have to pay the principal and interest back to creditors. Yet, just like companies, when these bonds are due, mostly they issue new bonds to refinance their debts. They’ll try to allocate this money to its best use, earn an additional income, and cover the cost of interest and other costs. Here is the financial market’s power: it can decide whether it lends to a government and how much is the cost.
What is EU debt crisis? EU debt crisis is the case in which financial markets, especially EU bond market, refuse or hesitate to lend more money to European governments to refinance their debts as they are afraid that these governments don’t have the ability to pay back those debts. If the financial markets refuse these governments (can be Greece, Spain, Portugal, Ireland…), these governments can have no money to continue their activity and therefore cannot grow their economy. This, in turn, puts more stress to repay the next debts in the future (like 3 months or 5 years later debts due, whatever time frame).
How do things turn out this way? First, governments do their own business. As a normal process they take debts to do larger/other things. In order to do this, governments go to financial markets to borrow money, this is second. To borrow money, governments have to let a rating agency like Moody, S&P, and Fitch to assert their financial/political/others conditions and rate them A B C in which A is the safest, hence, least interest cost required from financial markets. Governments then issue their bonds and investors invest (buy) bonds from the governments. Effectively, investors (public sector, private sector) provide money for the governments. In good time, the governments may earn steady income, have good growth, and have the ability to pay back debts and interest costs. Everybody is happy, the financial markets are happy to do business with a good governments and ready to lend more money if the governments need. In bad time, such as now in EU, governments do bad things, or have bad financial decisions. The market feels that these bad governmental practices will finally lead to undesired results. Therefore, the market starts to distrust the government and sells their bonds or requires a higher interest for the same amount of money. Rating agencies come and say to the government: “Hey! you’re doing bad, we’re going to cut your rating from A to B, you’re not safe anymore”. These governments then face to higher interest costs but if everything is under controlled, they may do good again and regain the trust of the markets. Yet if they cannot control the situation, the market will shut their door to the government and they cannot take more money from the market to continue their activities. Rating agencies will cut the government rating to C and this means: “This is a very bad investment, watch out!”. So this is what happened to Greece, processing through Italy and Spain, and threatening France. The results, so far, are the resignation of two Prime Ministers of Greece and Italy and a change in ruling party in Spain. Well, now see how financial pressure affects politics.
Political leaders now might extremely discomfort to the so-wide-affected power of rating agency like S&P, Moody, and Fitch. On the last November 30th, the Fed, Bank of Japan, Bank of England, and Swiss National Bank intervened and lowered Dollar swap rate by 50 basis points. This eased somehow the dollar liquidity stress faced by EU banks. EUR jumped 220 pips higher versus USD when the news came out. Two days later, S&P announced to put all EU countries to credit watch and therefore might downgrade their rating in the next 90 days. This threat pushed EUR down almost 200 pips lower versus USD. Then two day after that, S&P continued to threaten that the rating of the whole Euro Zone nations might be at risk and that France might be downgraded by 2 notches. This saying pushed EUR down for another 100 pips, cumulatively higher than the 220 pips up of optimism from Dollar swap rate easing. For the last week, most of the ups in EUR/USD was because of the hope on EU summit and USD liquidity support by national banks, meanwhile most of the downs was from S&P and other rating agency announcements. Finally, you might wonder S&P was just saying meanwhile the EU summit was real and the effort to save the Euro Zone was real as well as the liquidity support from national banks. But that saying reflected how the market thought about the current situation.
I’m extremely eager to see how the situation in Europe will evolve from this current debt crisis. Bond yields in Spain and Italy are cooled down significantly followed by efforts of EU leaders led by German Chancellor Merkel and France President Sarkozy. Yet the heat is still on and easily bursts into flame whenever the markets feel something uncomfortable. Finally the market goes for the best interests of the market and the governments also go for the best interests of the governments. They may cross somewhere in their ways and have to watch out what the other is doing.
There are interesting and notable examples on clashes between governments and the markets such as Japan foreign exchange market interventions, Swiss National Bank interventions in 2011, and Asia 1997 financial crisis. They are my favorite subjects and I’ll leave them another notes.