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European Finances Are Falling Apart

June 5, 2010

By Peter Boone and Simon Johnson

The big news is France.  With sentiment worsening across Europe, France has lost its relative safe haven status – credit default swap spreads on French government debt were up sharply today.

The trigger – oddly enough – was Hungary’s announcement that its budget is worse than expected (blaming the previous government; this is starting to become the European pattern) and in the current fragile environment discussed yesterday, this relatively small piece of news spooked investors.  But these developments only reinforced a trend that was already in place.

It did not help that the Irish Minister of Finance announced Ireland has 74.2bn euros of guaranteed bank loans, bonds, and systemic support falling due between now and Oct 1.  This is around 55% of GNP.  It sounds like everyone backed by the Irish government had the “clever” idea to roll over their debts to just before the guarantees expire.

The big losers are Portugal-Ireland-Italy-Greece-and-Spain as always, but Belgium is now in the line of fire, and France is clearly under pressure.  The spread between French and German credit default swaps (measuring the relative probability of default) is up – yesterday this was 40 basis points, today it stands at 44 (up from just 5 basis points at the end of 2009; most of the increase is since mid-March, with a sharp acceleration recently).  French bonds have become illiquid, with wide bid-ask spreads; not what is supposed to happen in a safe haven.  This is going to make the French angry – watch for more market slanders from top French politicians over the weekend; you know they would just love to ban trading in something.

Earlier today the French Prime Minister came out with a quote for the ages:

“I only see good news in parity between euro and dollar”.

Be careful what you wish for – such statements will drive the Germans crazy as they see further evidence that inflation lovers are clearly winning influence and might just gain control at the European Central Bank (ECB).

This has the potential to become a run on most non-German bonds in the euro zone.  Next we will see pension funds and reserve managers stepping back and waiting to see what happens – there is no profit in buying French bonds for a 40 basis point spread over Germany given the risks and illiquidity that we have seen in other markets.

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