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Euro crisis: What are they on about?

Europe’s debt crisis is looming large over the global economy. Reports are everywhere you turn, but they are often confusing. They tend to be heavy with jargon and light on background.

The following quote from a story published by Reuters recently is fairly typical.

“German debt prices rose and Spanish bond yields briefly jumped on Tuesday after Spain’s treasury minister said the country was effectively shut out of the market, but investors were reluctant to take new positions before a G7 conference call.”

For most people, that sentence may well have been written in a foreign language. Rising prices, jumping yields, upset Spanish ministers, indecisive investors and seven Gs. What on earth is he saying? Let’s break it down and see if we can make sense out of it.

“German debt prices rose”
Like the rest of us, governments incur debt by borrowing. But unlike the rest of us, they don’t borrow by taking out a loan. They borrow by selling bonds to investors. So when the author talks about debt prices, he’s really talking about bond prices.

Bond prices are initially set by government. Let’s say €100, for example. If an investor wants a 10-year German bond, that’s what he or she has to pay.

In return for his cash, the investor gets an annual payment based on the interest rate associated with the bond. If, for example, the €100 bond is paying a 2.0% interest rate, he or she will get €2 per year for the 10-year life of the bond. At the end of the 10 years, he’ll also get his €100 back. But this isn’t the investor’s only option.
Once an investor buys the bond, he owns it. He can either hold onto it until it matures, 10 years in this example, or he can sell it in the financial market. And that’s where prices change.

A lot of factors influence bond prices, but what matters in this case is risk. When investors get worried about the future, they become less concerned with making money and more concerned with keeping it. As a result, the demand for “risky” assets diminishes and the demand for “safe” assets rises.

Comparatively speaking, German bonds are considered very safe. Most investors believe that the German government will pay its debts. You won’t get rich off them, but you won’t lose your savings either. So when investors get fearful, their demand for the relative safety of German bonds rises. This drives up prices. The same thing has been happening with US, Japanese and Swiss bonds.

“Spanish bond yields briefly jumped”
This part of the quote could just have easily read “Spanish debt prices fell”. It’s the flip side of the risk coin. Spain is confronting a slew of problems, high government debt levels, high unemployment, a contracting economy and an ailing banking system. As a result, investors see a lot of risk in Spain. This diminishes demand for Spanish bonds and drives prices down.

And that is where yields come into the picture. A bond yield is an investor’s return on investment. Yield can be calculated based on a bond’s current price. If the €100 bond we just discussed is paying a 2.0% fixed interest rate and can still be bought for €100 in the bond market, then its yield is 2.0%.

If the bond’s price falls, however, as it has recently in Spain, then the yield will go up. Remember, at the end of the bond’s life, whoever owns it will get a payment of €100. So if price falls and an investor is now able to buy a bond at €95, he still gets an annual payment of €2 plus the €100 in the end. In other words, he’s getting a higher return. This higher return is reflected in the bond’s yield.

The maths can get confusing here, but the principle is straightforward. The important thing to remember is that bond prices and bond yields move in opposition to one another. Think of a see-saw with a kid called Price sitting on one end and a kid called Yield sitting on the other. When Price goes down, Yield goes up.

“After Spain’s treasury minister said the country was effectively shut out of the market”
Yields aren’t just an indication of return for investors. They are also an indication of borrowing costs for governments. Remember, governments have to pay the interest that investors receive.

If Spanish bonds are yielding 6% in the market then any new bonds that Spain sells will have to be pretty close to that rate in order to attract buyers. By saying that his government was “effectively shut out of the market”, Spain’s treasury minister was essentially saying that the interest rate investors wanted to charge on loans was prohibitively expensive for his government. He simply can’t afford to borrow because he can’t afford the interest payments.

There is, arguably, a bit of hyperbole at play here. But the minister is making a valid point. When other European countries saw their bond yields rise above 7.0%, they were forced to seek external financial assistance. In Greece’s case, borrowing costs rose so high that the government was forced to renegotiate the terms of its debt with investors.

“But investors were reluctant to take new positions”
Investors like certainty. If they are fairly confident that prices for German bonds will increase and Spanish bond prices will decrease, they’ll buy and sell accordingly.

What the author is saying here is that the situation in Europe is so uncertain at present that investors are reluctant to make a decision one way or the other. One reason for this hesitance is that policymakers have yet to decide on how best to handle the continent’s crisis.

“Before a G7 conference call”
The Group of Seven (G7) consists of the seven largest economies in the world. These countries have enormous financial resources at their disposal. If they choose to act to support Spain, through a bailout of the country’s banks or large-scale purchases of the country’s bonds, for example, they could drive yields and borrowing costs down, at least temporarily.

You could substitute “European Central Bank meeting” or “International Monetary Fund gathering” for “G7 conference call”. The effect on markets would be largely the same. Any of these institutions has the ability to intervene in such a way as to shift prices.

For example, in the past, the European Central Bank began buying Italian bonds when yields started climbing. This pushed bond prices up, yields down and lowered the country’s borrowing costs.

Pulling it all together
The fear with all this is that if bond yields climb too high and borrowing costs become unmanageable, governments may default on their debts. Because banks and other institutions hold a lot of government debt, this would cause a huge shock to the world’s financial system.

For years now, Europe has been trying to get debt levels under control through a programme of “austerity” – tax rises and spending cuts. Some economists think this cure is worse than the ailment.

By forcing governments to reduce spending and raise taxes in the midst of a recession, they argue, policymakers are actually making the problem worse. They are making less money available to businesses to invest and consumers to spend. This slows the economy. Cruelly, it also means that there is less money available to pay interest on existing debt.

It’s a mess and, unfortunately, one that looks likely to be with us for awhile. At least now you’ll know what it’s all about.