Portuguese recycling & Iceland recovery -- Why the Chinese and Japanese are buying EU debt

The recent news of both China and Japan buying EU debt provides a very interesting window into the various motivations of investors.  While most investors are leaving the PIIGS debt markets, China and Japan appear very willing to invest.  Why?  It appears the Asian nations' motivations are different than return of principal.  Both are exporting nations and if more European trading partners are forced into austerity measures of higher taxes and lower government spending their own export industries will suffer.

American policy makers should be mindful of this when negotiating with China. It may appear they have the upper hand when looking at their massive foreign exchange reserves, but China also needs our markets to keep their factories running.

Unfortunately Portugal looks to be the next domino to fall, Asian assistance notwithstanding.  FT's blog lays out the timeline I have previously alluded to: It appears once a PIIGS' bond yield pierces the 7% level a bailout eventually follows.

However even with these 'bailouts' and Euro Central Bank assistance the problem has not been solved. As austerity measures and budget cuts drag GDP down the burden of debt grows ever higher in a nasty feedback loop.
From Satyajit Das:

Cuts in government spending and higher taxes have mired the economy in recession. Falls in tax revenue necessitate increasingly deeper cuts in spending to try to stabilise public finances. In 2010, the budget deficit was forecast at 12% of GDP, even after spending cuts and tax rises worth Euro 14.5 billion   The problems of the banking sector are increasing due to the poor economic conditions. Hitherto largely confined to commercial property, problems are now spreading to the broader economy. Unemployment and lower incomes mean that householders are unable to meet payment obligations on mortgages and other loans. Weak economic conditions have affected businesses, increasing default levels. In the absence of strong economic growth, inflation and a massive devaluation, the peripheral economies, such as Ireland and Greece, may be unable to shrink themselves to solvency. A simple relationship demonstrates the unsustainable position:

Changes In Government Debt = Budget Deficit + [(Interest Rate – GDP Growth) X Debt]

In order to restore solvency, overburdened borrowers must stabilise debt and begin to reduce the level of borrowing. This requires GDP Growth exceeding interest rates, a budget surplus (through spending cuts and/or tax cuts) or a combination of these. EU/ IMF assistance to Ireland was designed to address the high yields on Irish bonds, which curtailed the State’s ability to borrow. But the 5.80% cost of the bailout debt requires an equivalent growth rate and a balanced budget simply to stabilise debt at current very high levels.

Meanwhile the recovery in Iceland provides contrast to the current austerity and higher tax drudgery in the weaker European countries:

The Nordic economy grew at 1.2pc in the third quarter and looks poised to rebound next year. It ends a gruelling slump caused largely by the "New Viking" antics of Landsbanki, Glitnir and Kaupthing, the trio of lenders that brought down Iceland's financial system in September 2008. . .

This has led to vastly different debt dynamics as they enter Year III of the drama. Iceland's budget deficit will be 6.3pc this year, and soon in surplus: Ireland's will be 12pc (32pc with bank bail-outs) and not much better next year . . . 

The pain has been distributed very differently. Irish unemployment has reached 14.1pc, and is still rising. Iceland's peaked at 9.7pc and has since fallen to 7.3pc.

Ahead of schedule PIIGS bond yields make new highs

Ahead of schedule bond yields in the PIIGS of Europe have reached new highs.   'Risk Free' interest rates have risen as well since November so the relative spread may not be at a new maximum yet but the trend is going the wrong way.

Something to watch in the new year

The year is wrapping up and the US stock market continues to grind higher in a Christmas rally. While the US is in a much calmer state as compared to a year ago, not all is well across the pond in Europe.

The fiscal crisis in the PIIGS of Europe (Portugal, Ireland, Italy, Greece, Spain) has not been 'fixed' in my opinion and will most likely move up to the headlines in America very shortly.

Here you can see a chart of the PIIGS bond yields  (Bloomberg) and they are not going in the right direction. The spike and fall in May 2010 was due to Greek financial difficulties and the spike in November was from Ireland. Note how much faster the fall in yields after the Ireland event has been retraced as compared to the Greek event.

As this chart shows the absolute yields and not the relative 'risk' of the PIIGS regions looking at the combined CDS for the PIIGS (Bloomberg) provides a clearer view of perceived risk.  It too is almost at new highs and could very well exceed previous peaks before the new year.    I suggest you keep an eye on both of these indicators and if you see them shooting higher you will most likely see weakness in the equity markets as well.