Posted on June 1, 2012

Crisis Mounts

The triple whammy of a rotten U.S. jobs report, slowing growth in China and India, and the escalating European debt crisis has hit Canada’s economy and financial markets everywhere.

Stock market indexes are plunging, and other signs of distress are proliferating. The drop in commodity prices—reflecting weakening global demand—has hit Canada and Australia hard as mining companies are now postponing investment.

Ironically, this is only a week after the OECD recommended that the Bank of Canada hike rates, which of course, will not happen anytime soon. Indeed, today’s very disappointing U.S. jobs report has triggered calls for further easing by the Federal Reserve (so-called QE3). Even before the latest weak data, we were in very dangerous territory, owing to the downward spiral in the Spanish and Italian bond markets and broadening concerns of a break-up of the eurozone. Turmoil in Europe has exacerbated the slowdown worldwide as European banks retrench, reducing their lending to Asia and elsewhere, and capital flees to safe havens such as the U.S., German and Canadian bond markets. Bond yields in these countries have fallen to record lows. With China’s growth slowing, the loss of economic momentum in the U.S. is particularly troubling. The U.S. rebound could have cushioned the blow of Asian and European slowing, but now that is in question. American businesses are reluctant to hire when there is so much uncertainty regarding taxes, financial regulation and health care costs.

Banks are reluctant to make loans when European banks are set to topple, regardless of stopgap government measures to prop them up. Central banks and central governments are running out of bullets. Interest rates are already at record lows in most countries (excluding, of course, Spain, Greece, Ireland, Portugal and Italy) and pressure to reduce budget deficits limits the willingness of governments to stimulate. Stock market nosedives and declining consumer confidence reflect this policy paralysis.

The eurozone’s tottering banking system is threatening to take down the weakest eurozone governments and their bond markets. The banks are the biggest owners of government debt and governments are increasingly becoming the owners of the banks.

Bank losses are increasing sharply, especially in countries, such as Spain, that have suffered huge housing crashes. This, in turn, drives cash out of the banks and sovereign debt, further worsening the dangerous death spiral. Earlier in the crisis, Ireland was able to keep Anglo Irish Bank from insolvency by giving it a promissory note at the cost of ballooning Ireland’s budget deficit. Prior to 2007, Ireland enjoyed a decade-long real estate boom during which easy bank credit prompted enormous overbuilding as bank stocks surged, mirroring the situations in the U.S. and Spain.

With the 2008 financial crisis and housing collapse, Ireland announced a 400 billion euro guarantee scheme covering its six main banks, including Anglo. By early 2009, the government nationalized Anglo, despite later-confirmed rumours of the bank’s fraudulent activity. Irish taxpayers are still paying the price and the Irish government is still unable to borrow money in the open market. Ireland saved the banks at the cost of its own government coffers and was consequently strong-armed into a eurozone rescue plan. Greece had to give four of its banks €18 billion worth of bonds from the rest of the eurozone, funnelled via the European Financial Stability Facility. Rumours arose earlier this week that Spain would prop up Bankia by giving it €19 billion of Spanish government bonds to take to the ECB as collateral to borrow the funds the bank needed. The ECB denied receiving such a plan, but the speculation still caused massive gyrations in global capital markets. Spain is engaging in a very risky policy: it runs the risk of causing a dramatic further rise in its borrowing costs, reducing its own solvency, to save its banking system.

Moreover, no one knows if Greece will exit the eurozone, but the odds of it are rising. The impact of Greek withdrawal is impossible to predict, but businesses, banks and governments are making contingency plans. Already, trade-credit insurers are unwilling to provide export insurance to multinational businesses that sell products to Greece, which will inevitably cut off supply. Capital is moving out of euros into safer currencies such as the U.S. dollar, Swiss franc, British pound and Japanese yen. In turn, this reduces the export competitiveness of these countries at a time when unemployment is high and domestic demand is at risk.

The Bottom Line: The crisis shows no sign of abating and the slowing in global growth will continue apace.

The enormous decline in U.S. and Canadian bond yields is a sign of extreme investor distress. The European debt crisis is quickly coming to a head and the policies of austerity and ECB support will no longer be sufficient to calm markets and buy some time. Political upheaval is already evident in Europe and governments can no longer impose austerity measures without popular uprisings. German willingness to take on more of the liability is in question; and, until that issue is resolved, the eurozone’s viability is uncertain.