The root of European debt crisis

The European debt crisis has been the spotlight in the world. One question we may raise quickly is : what the hell root of this crisis? In order to answer this question, let us take a look at Finland, one of six AAA rated euro countries, which may face a similar fate to junk-graded Portugal in the next decade.

The northernmost euro member grapples with the decline in its two main industries, technology and paper.

Mobile-phone maker Nokia Oyj’s take off in the 1990s to become the world’s largest mobile-phone maker helped pull Finland out of recession. At the peak in 2000, Nokia accounted for 4 percent of Finland’s GDP. But now, the company’s days as the powerhouse of Finnish growth are over. Nokia has announced 1,900 job cuts in Finland since last year, or 10 percent of its local workforce, as its market value plunged almost 50 percent since January.

Europe’s two biggest papermakers, Stora Enso Oyj and UPM-Kymmene Oyj, was built on its forests. Since the 1960s, the country’s pulp industry has languished as emerging markets produce cheaper timber.

As the underlying competitiveness is diminishing, the problem across the Europe has been escalated in Finland: an imbalance in public finances exacerbated by the aging population. The number of workers for every pensioner will drop to three from four by 2015. That’s about five years earlier than in the rest of Europe.

While the government is not able to generate enough capitals to fund the spending, like a company, it must raise debt. In Finland’s case, it is estimated that debt will swell in 2011 to more than 50 percent of gross domestic product from 34.1 percent three years ago.

What happened in Ireland

Ireland had a AAA rating, a lower debt level than Finland and a surplus in its public sector, but then the crisis hit and the situation changed rapidly. Moody’s Investors Service cut Ireland to junk on July 2011, arguing the 85 billion euro ($119 billion) bailout may not be enough to keep it afloat. While Ireland’s plunge was linked to over-leveraged banks, its example remains relevant for economies where growth can’t keep pace with government spending.

Europe’s debt crisis has shown that failure to tackle fiscal weakness in time can force governments to impose severe austerity measures later. If there are no turnaround in the corner, Finland risks having to take emergency action” to fix its finances if the country’s budget drain isn’t fixed promptly.

So who would be the superstar to engine the Finland’s economy if the government is still struggling to find a unity need for cuts? The “Angry Birds”? Is it a lesson that the economy is focused on too few industries which is case similar to the lack of diversification in investment?

Credit rating agency faces government's challenge

Credit-ratings companies may be forced to disclose the internal analyses they use when they decide to cut a European Union government’s rating, the region’s financial services commissioner said.

Nations may win the right to check the data used by the companies in advance of downgrades of their sovereign ratings. The battle derived from Moody’s Investors Service’s cut of Portugal’s credit rating by four levels last week, prompting criticism from the EU that ratings companies are unnecessarily exacerbating the region’s sovereign-debt crisis. European Commission President Jose Barroso, who is a portuguese, said he “deeply” regretted the timing and magnitude of the downgrade and said proposals for increasing regulation of the rating companies in Europe would come out this year.

The governing body is considering introducing requirements which would allow a government to check the accuracy of the data used by an agency in advance of any downgrading. The proposals may also include measures for investors to take ratings companies to court when there has been negligence or violation of applicable rules. They want more competition and diversity in this business.

On the other side, governments shouldn’t abuse the ability to check the data used by ratings firms by attempting to delay downgrades to their sovereign rating. It is human nature that governments whose ratings are downgraded are often too ready to shoot the messenger rather than tackle their debt problems.

Reversing Stimulus is under consideration

G-8 finance ministers began drawing up contingency plans for rolling back budget deficits and bank bailouts as the economy shows signs of recovery and investors start worrying about inflation.

It’s prudent to consider what exit strategies to deploy once global growth is secured and how to do so without reigniting the two-year crisis. At the same time, it’s premature to rein back more than $2 trillion in stimulus packages.

But some politicians stressed the necessary to continue focusing on the growth now, it is too early to shift toward policy restraint according to the speech by U.S. Treasury Secretary Timothy Geithner.

The dilemma for policy makers is that withdrawing stimulus measures too soon could choke the recovery before it starts, and allowing them to last too long might push up borrowing costs.

Markets aren’t looking for specific exit strategies now, but want governments to start thinking about them. They worry that inflation is going to build up if nothing is done to withdraw the stimulus.

Foreign demand for US financial assets falls

Foreign demand for long-term U.S. financial assets fell in April as both China and Japan trimmed their holdings of Treasury securities.

The Treasury Department said Monday that net purchases of stocks, notes and bonds obtained by foreigners fell to $11.2 billion in April, from $55.4 billion in March.

China, the largest holder of U.S. Treasury securities, trimmed its holdings to $763.5 billion in April, from $767.9 billion in March. China's holdings of Treasury securities represent about 10 percent of America's publicly held debt. Japan, the second largest holder of Treasury securities, reduced its holdings to $685.9 billion, from $686.7 billion a month earlier.

Treasury Secretary Timothy Geithner traveled to Beijing earlier this month to assure the Chinese government that the Obama administration is determined to get control of an exploding U.S. budget deficit, which is projected to hit a record $1.84 trillion this year. The administration has said while its aggressive moves to fight the recession and a severe financial crisis will push up the budget deficit temporarily, it intends to reduce the deficit as soon as the economic situation permits.

With the government's borrowing needs soaring, there have been some concerns that foreign interest in holding U.S. debt might falter, causing interest rates to rise.

The administration contends that recent increases in the interest rates for U.S. Treasury securities were not a sign of investor unease but a reflection of improving economic conditions.

Can new lending drive China economy freely?

China’s new lending doubled in May and industrial output and retail sales climbed more than economists estimated as government stimulus spending revived the world’s third-biggest economy.

New loans jumped to 664.5 billion yuan ($97 billion) from 318.5 billion yuan a year earlier. It add to accelerating fixed-asset investment and surging auto and property sales in signaling that the government is successfully countering a slump in exports. Record lending is stoking concern that China’s recovery may come at the expense of inflating asset bubbles and adding to banks’ bad loans. The pace of bank lending is dangerous and the risks include inflation, bad loans and economic volatility.

But the recovery is still fragile since this is an economy that is increasingly reliant on public demand. Aside from private residential property investment, private demand remains soft.

On the other hand, the rapid growth of credit should be regarded as a warning sign. In china, nearly always when we have financial difficulties at banking institutions, it’s preceded by rapid growth in lending.

The credit boom may help to end declines in consumer prices, however, inflation may bounce back faster than economic growth.

Yields Tumble as Credit Market thawed

Investors are snapping up new corporate bonds at the fastest pace since May, driving down yields from record highs once they begin to trade.

New issue performance has been exceptional, it reflected a realization of the value in investment-grade credit.

The extra yield investors demand to own Tyco International Ltd. ’s $750 million of 8.5 percent notes due in 2019 has narrowed to 5.3 percentage points, from 6.81 when they were sold Jan. 6. spread on Volkswagen AG’s 1.5 billion euros of 6.875 percent 2014 bonds has shrunk to 4.34 percentage points from 4.53 on Jan. 7.

The rally shows that the freeze in credit markets that led to $1 trillion in writedows and losses at the world’s largest financial institutions is starting to thaw. Rising confidence in corporate bonds may help non-financial companies that need to replace $135 billion of debt this year in the U.S.

Bond yields compared with government debt more than compensate for the risk of rising defaults caused by the global recession. Returns may creep into double digits this year as governments rescue more businesses.

Other measures of risk also point to an easing in credit markets. The difference between what banks and the U.S. Treasury pay to borrow money for three months, the so-called TED spread, narrowed to 0.99 percentage point, the tightest spread in five months, after peaking at 4.64 percentage points in October following Lehman’s bankruptcy.

Bonds are rallying even as an increasing number of companies comes to market, with sales excluding banks rising this year to $49.9 billion in the U.S. and Europe from $16.8 billion in the same period in 2008, according to data compiled by Bloomberg. This month is the busiest since May.

Since peaking at a record 656 basis points on Dec. 5, the yield gap on U.S. investment-grade company debt has shrunk to 557 basis points, handing investors a return of 6.78 percent, according to Merrill Lynch index data. At the same time, U.S. government debt is paying near-record low yields.