Another one bites the dust - Outside View by Asad Dossani

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Another one bites the dust
Apr 11, 2011

The Eurozone debt crisis is back in the news. Over the past few weeks, the headlines have consisted of various Portuguese government ministers emphasizing that they do not need a bailout. Just like the Greeks and the Irish claimed that they did not need any assistance, so too did the Portuguese. And like their predecessors, they ended up asking for a bailout anyway.

Most of us know not to trust politicians. The difference between what these government ministers say and what they actually do could not be greater. The market was not fooled though. Portuguese bonds yields have remained stubbornly high in anticipation that a bailout would be requested.

Earlier this week, the European Central Bank (ECB) became the first of the major Western economies to raise interest rates. In a widely anticipated move, the bank raised interest rates from 1% to 1.25%, still at a very low level. The stated reason for the rate rise was increasing inflationary pressures. As the ECBs mandate is price stability, they had to raise rates despite the problems higher interest rates will cause for indebted Eurozone nations.

The European countries that have been strong economic performers (i.e. Germany) would benefit from a rate rise. Inflationary pressures would be reduced and growth would continue without the economy overheating. For the heavily indebted countries, this rate rise could not have come at a worse time.

Most of the indebted countries are heavily reliant on floating rate debt. As a result, any increases in the interest rate hurts their economy directly as their interest payments go up.

In the short term, Portugal has the difficult task of negotiating a bailout package. A month ago, the government tried to implement austerity measures but was unable to. The EU finance ministers will be expecting Portugal to demonstrate that they are taking concrete steps to reduce their debt levels, and this is likely to be difficult from a political perspective.

Portugal is expected to ask for approximately 80 billion euros over a three-year period. The EU and the IMF will jointly finance this. A certain amount is expected to be used to stabilizing the banks. In return, they will be expected to implement austerity measures and privatize many state-owned assets.

It remains to be seen whether or not these bailouts will work. Effectively, these bailouts are simply new loans to pay off old ones, except that these loans are provided by the EU and IMF instead of private investors. Chances are that these countries will have trouble in a couple of years time when it comes to paying these back. Using one credit card to pay off another is not a very sensible strategy.

On a final note, since Portugal asked for a bailout, there has been renewed speculation about Spains financial position. EU minister Olli Rehn, when asked about Spain, was confident that Spain would not need a bailout. As I said before, most of us know not to trust politicians.

Disclosure: I do not hold the currency/commodity discussed in this report.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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