Italy Is Too Big To Bail, Even For France And Germany

by Agustino Fontevecchia

As contagion sends ripple effects through the European periphery, with Italy in the eye of the storm amid rumors that the European Central Bank (ECB) has intervened and bought Italian sovereign bonds on the secondary market, analysts are coming to the conclusion that Italy is too big to bail given massive funding requirements and total debt outstanding of €1.6 trillion ($2.2 trillion).

Italian equities managed to record some gains during Tuesday’s session, up 1.3% after a terrible two-day beat-down that led to some of the largest spread moves in sovereign bonds in the European Monetary Union’s History and to what Italian’s called “Black Friday”. Yields on benchmark 10-year Italian bonds fell marginally on Tuesday and stood at 5.66%, just below Spain’s 5.96%.

With a plethora of negative news coming out of Europe on a daily basis, it is hard to attribute this Italian crisis to one event, but what is undeniable is that markets are coming to the realization that Italy is a whole different animal from Greece, Ireland, and Portugal, and that bailing it out might deliver a final blow to the beleaguered European Union. (Read Euro Contagion: Italian Equities Tank, Yields And CDS Jump).

Differences are staggering. While funding requirements for 2012 the three PIIGs that have already been bailed out totals €91 billion ($127 billion), Italy’s funding requirements reach a massive €250 billion ($350 billion). Total outstanding debt for the country run by Prime Minister Silvio Berlusconi is around €1.6 trillion ($2.2 trillion), compared with €345 million for Greece, and about €150 billion each for Portugal and Ireland, according to numbers crunched up by Nomura.

If Italy were to fail, the problem would be that it is too big to bail. Nomura’s analysts point out that current European Financial Stabilization Facility (EFSF) mechanisms were designed to deal with failure of relatively small countries being bailed out by a relatively large group of participating Eurozone countries. The equation changes for Italy.

Currently, the EFSF has an effective lending capacity of €320 billion ($448 billion) out of a total of €440 billion ($616 billion); Italy’s funding needs over the next two years exceed €500 billion ($770 billion). Not only would the EFSF (and its successor, the European Stability Mechanism-ESM-with total authorized capital estimated to be around €700 billion) lack the capacity to bail out Italy, the number of countries ready and willing to lend Rome a hand would be reduced to only two: France and Germany. (Read French Banks Hold $93B In Greek Debt As Sarkozy Announces Rollover Deal).

If Europe’s two big dogs were forced to cough up €500 billion for their Italian buddies, that would constitute approximately 10% of their combined GDP (around €5 trillion, according to Nomura). According to the note:

At some point the load will be too big for France and Germany too. For example, would France be able to sustain an AAA rating with contingent liabilities to Italy in excess of 10% of GDP?
There is not enough capacity to bail out Italy within the current bail-out infrastructure. And even an expanded EFSF may not be able to provide a credible backstop over the medium-term

One possible alternative is central bank intervention to lower rates. Traders on Tuesday were pretty sure they saw the hand of the ECB, through the Bank of Italy, in sovereign bond markets for Italian debt in a day when the y auctioned off €6.75 billion of Italian debt at a much higher rate than usual. And on Monday, a meeting of European Finance Ministers allowed for the possibility that the EFSF could be allowed to buy sovereigns in the secondary market. (Read Europe’s Debt Grind, Worry Over Italy Keep Traders Jumpy).

But this might not be enough, as FT Alphaville notes. While the ECB has already tried these interventions with Greece, Portugal, and Ireland, it has not succeeded in ensuring “depth and liquidity in those market segments which are dysfunctional,” as trade volumes in those suggest. And, given the size of the Italian bond market, with “daily turnover in May of €12 billion” and gross issuance in the third quarter of €31 billion in two, five, and ten-year bonds, it would be a disaster for the ECB to make Italy “a regular patient.”

The situation is dire indeed. The political battle to bail-out small nations in Germany was massive, eroding much of Chancellor Angela Merkel’s political capital. Bailing out Italy, then, seems like an economic, political, and social impossibility.

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A Manic Market

by Bespoke Investment Group

Just one week after the S&P 500 finished off an historic stretch where all 24 industry groups finished higher on four out of five days, the index has now had two straight days where all 24 groups were down. That makes it six days in the last ten where all 24 groups finished the day in the same direction (up or down). Looking back over the last ten years, there have only been three other periods where this has occurred. Those occurrences are highlighted below and came in August 2007, November 2008, and June 2010.

As shown in the charts, the last two occurrences came near intermediate-term market lows, but the occurrence before that came in the midst of the S&P 500's last ditch attempt to rally right before the long bear market began. Apropos to the title of this post, these occurrences have preceded big moves (up or down) in the market, so a stable and sleepy Summer of trading is probably out of the question.

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The European Job

By Barry Ritholtz

The following was written by Jawad Mian, Portfolio Manager based in Doha, Qatar

~~~

In 1947, Harry Truman delivered a speech before a Joint Session of Congress which became famously known as the Truman Doctrine. Back then, the world feared Greece would fall to Communism in an era of Cold War politics. The stability of the whole Mediterranean depended on Greece not falling it was argued. Truman’s speech was dramatic and exposed a grave national security threat, “If Greece should fail… the effect upon its neighbor would be immediate and serious. Confusion and disorder might well spread throughout the entire Middle East. Should we fail to aid Greece in this fateful hour, the effect will be far reaching to the West as well as to the East. We must take immediate and resolute action.” There was no other option. Greece had to be saved. Looking at FT today, the parallels are clear. The fateful hour has made a return.

Truman justified his aid to Greece by bringing up World War II. The United States had contributed $341 billion toward winning the war, which he referred to as an “investment in world freedom and world peace”. The assistance that he recommended for Greece amounted to little more than 1 tenth of 1 percent of this earlier investment. He believed that it was only common sense that the United States should safeguard that investment and make sure that it was not in vain. “This is a serious course upon which we embark,” he alleged, “I would not recommend it except that the alternative is much more serious.” Not that I really care but I’m quite sure European policymakers feel pretty much the same right now. They have vested much time and effort to harness the European Project. The alternative is unthinkable. It is only common sense that they too should safeguard their “investment”.

But there is more to it than that: The ECB is insolvent. They have roughly €200 billion in Greece related debt. Assuming even a 50 percent haircut on Greece debt would be tragic as the central bank’s own capital and reserve base of €80 billion could be wiped out. I can’t imagine ECB being caught naked like that. That would be embarrassing. The ECB would then have to go cap in hand to national central banks for a recapitalization. Not cool! Trichet is leaving the ECB this fall, I’m certain he does not want to be remembered as the ECB head that presided over a European default. That would kill his legacy. He definitely wants to leave on a happy note, who wouldn’t? That way, he can write a memoir (memoire in French) about how he saved the European Project from complete collapse. I’m sure people would want to believe that, I mean read that. He could call it The European Job.

The point is Europe can’t yet afford a fully fledged sovereign bond default, even in a tiny economy like Greece. Buying time is critical. Spain is too big to bail and it must cheat default. European banks have increased their capital by almost 50 percent but that is still not sufficient to absorb losses. Exposure to Italian sovereign debt and banks equates to about 50 percent of French banks’ book value. Ergo, France gets screwed. It is easy to see the collateral damage would cause plenty of havoc. But complacency is again creeping in at the ECB which is worrying. The pussy-footing must come to an end. In due course, I believe the ECB will give in to pressure from markets and provide additional monetary stimulus (read: outright monetization of sovereign debt) once Italy and France enter the fray. The political will is stronger than the public angst at the moment. That is why Greece will be bailed and the problem contained.

In less than two years, however, the balance of power will shift. Popular discontent for bailouts will mushroom. The public will not be able bear the pain that comes with “austerian” economics. The Greeks will default and not be apologetic about it. Greece has defaulted or rescheduled its debt five times since gaining independence in 1829. In fact, since its independence, Greece has spent 50 percent of those years in default or rescheduling. That’s possibly the worst track record for a country in all of Europe. I don’t know about you but I wouldn’t want to lend to that. Instead, I’d encourage them to default. But my suspicion is that the Greeks don’t need my encouragement. They know what is in their best interest. They have been through this before – many times – and they already know how this will end.

During the time of the Great Depression, roughly 50 percent of the world’s countries either defaulted on or restructured their sovereign debt. The official bailout lending during that time was sponsored by the League of Nations (IMF duplicate). Greece received two loans, one in 1924 and another in 1928. The global crisis hit in 1931, trade collapsed and prices tumbled. Debt service became problematic. Insolvency and default became inevitable. The gold standard had been restored almost everywhere during the mid- to late-1920s and that was making matters worse. Greece left the Gold Standard on April 26, 1932 and declared a moratorium on all interest payments – the only European country to do so at the time. Greece adopted protectionist policies such as import quotas, and coupled with a weak drachma, stifled imports, allowing Greek industry to expand during the Great Depression. By 1939, Greek industrial output was 179% that of 1928. Problem solved.

I remind ourselves of this episode to restore a bit of perspective. For Greece to leave the European Union (and give up on the common currency regime) would not be a new thing. There is clear precedent. The laws can change. For now, I expect the real crisis to be averted. Markets will riot momentarily to force policymakers into action. That is not surprising. I believe in the natural cynicism of the marketplace to the political optimism of governments. Across Europe, social tensions will continue to simmer and economic stress continue to accumulate. The sovereign debt crisis will continue to be a contentious point that will periodically provoke financial market volatility. Looking over at Europe, the economic equation is clear. The political divide is what must be clearly understood. Ultimately, The European Job will not be successful without deeper unification. Looking at the ongoing regionalization and different alliances within Europe, I don’t see how that is even remotely possible.

The political fate of Europe is uncertain. But we are likely to see major political shifts as governments get blamed for eroding living standards, high taxes, and pressure to cut spending. By 2020, the average EU country would need to raise its tax rate to 55 percent of national income to pay promised benefits. Imagine that. One thing is clear, the virtuous cycle of the past many years is ending and a vicious one is about to begin.

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Dollar Index: Constructive, but…

by Guy Lerner

Figure 1 is a weekly chart of the Dollar Index (symbol: $DXY), and it is the same chart I have been showing for weeks. Not surprisingly, this week’s break above the downsloping trend line coincides with weakness in equities. The 74.62 key pivot becomes our new level of support.

Figure 1. $DXY/ weekly

The price action for the Dollar has been constructive from the bottoming process to the recent consolidation. But resistance is looming overhead, and it is rather significant suggesting that a break above these levels would deal a crushing blow to equities, which seem to trade in the opposite direction of the Dollar Index. This resistance can be seen in figure 2, a weekly chart of the Dollar Index, and it is defined by the following hurdles: 1) the 40 week moving average; 2) the key pivot at 76.28; 3) the up sloping orange trendline, which represents the prior breakdown point.

Figure 2. $DXY/ weekly

In sum, the price action in the Dollar Index is very constructive. Resistance remains significant and a break above would likely coincide with equity weakness.

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Is Brazil Stock Market Putting Up A Bearish Warning Flag?

By: Steven_Vincent

Brazil's Bovespa stock market index closed at fresh lows today. It's rally off the early July low was far weaker than that of most other major world markets. A look at the chart shows that a significant level of support going back to October of 2009 was violated in today's selloff.

In fact, the index is just a day's trade away from taking out its May 2010 lows. Is Brazil sending a warning to global investors?

For many investors, the continuation of the rally in global stocks since March 2009 is predicated upon the BRIC and Emerging Market growth story. Brazil is a major representative in both groups of economies. While its annualized GDP growth rate remains high at over 4%, it's down by over 50% since the third quarter of 2010.

It's certainly possible that Brazil's stock market is just marching to the beat of its own drummer and there may not be a tight correlation with general world equities markets. It's interesting to note that Bovespa bottomed in May of 2010 when the major selloff in the markets in most of the rest of the world was just getting under way. But nonetheless, if the market of one of the economies presumed to be a leader in the world economic growth story is falling into a bear market, investors should take note and evaluate the implications.

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China's Bailout Of Europe Has Started, As The PBOC Joins The SNB

by Tyler Durden

As of this morning China has migrated from a purely symbolic European White Knight to an actual one. While overnight trading action was set to recreate the panic from September 15, 2008, suddenly something changed. That something? China. Per Dow Jones: "Bunds give up nearly all of Tuesday's early gains with the September contract just 12 ticks higher on the day at 129.26 after making a spike at 130.91, a gain of 177 ticks from the open. The latest, unconfirmed, rumor pushing bunds lower is that China is behind the supposed ECB enquiries for peripheral debt prices. As yet no official confirmation from market sources of any central bank buying. In the cash space, the 2-year yields 1.235% and the 10-year 2.65%." As China has been actively buying up EURs over the past two months and is now massively underwater on a cost position that may be in the hundreds, but is certainly in the tens of billions of dollars, the ongoing collapse in the EUR currency will now force the PBOC to resort to increasingly more drastic measures to protect its strategic investment. The irony of this is that the Swiss National Bank, which this morning had to watch in horror as the EURCHF plummeted to 1.15 and for the longest time has been fighting the Fed (which loves a strong EUR) has been joined by the PBOC, which is now also trading on its behalf. The First Central Bank War is now officially on.

And some other observations on why nothing can prevent the rout, since the euro zone is now actively contemplating a Greek bankruptcy:

The euro zone acknowledged for the first time some form of Greek default may be needed to cut Athens' debts, but markets seized on the lack of a deadline for action and a lukewarm response from the IMF to heap pressure on Italy and Spain.

Dutch Finance Minister Jan Kees de Jager said on Tuesday euro zone finance ministers had effectively accepted that if they wanted to have the private sector involved in a second bailout of Greece, a selective debt default was likely, despite the European Central Bank's vehement opposition to such a move.

"We have managed to break the knot, a very difficult knot," he told reporters as he arrived for a second day of talks.

Asked about whether a selective default was now likely, he replied: "It is not excluded any more. Obviously the European Central Bank has stated in the statement that it did stick to its position, but the 17 (euro zone) ministers did not exclude it any more so we have more options, a broader scope."

Participants said both a buy-back of Greek debt on the secondary market and a German proposal for a bond swap for longer maturities were under consideration after a complex French plan to roll over bonds made no headway.

Both would likely be regarded by ratings agencies as a default, or at best a selective default, which could have profound repercussions for financial markets.

The lack of immediate action and the increased likelihood of some form of default sent European bank stocks and debt markets into a spin and propelled the euro sharply lower against the dollar.

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Morning markets: Greece and Rome fears extend crops' fall

by Agrimoney.com

If Tuesday is to be a turnaround one, it was in heavy disguise in early deals.

Chicago lore has it that the second day of the week tends to reverse a strong trend in the first one. Which, given Monday's weak performances, including a limit-down finish in cotton, implies rises today.

However, that was to reckon without Greece and Italy which, having given world civilization so much, are currently forces for destabilisation.

If tackling Greece's sovereign debt burden has proved a headache, and on Monday prompted banks to pressure European Union for assurances, should the problem spreading to Italy, with more than $2.2 trillion of outstanding debt, well….

"Once Italy gets involved, it starts to be a situation that politicians alone may not be able to solve," Jim Reid, credit strategist at Deutsche Bank, said.

Macro fears

And with concerns still abroad about Chinese inflation, and over poor US employment data on Friday, the stage was set for more liquidation of risk assets.

Tokyo's Nikkei share index closed down 1.4%, falling back below 10,000 points, while Shanghai stocks were 1.7% lower in late deals.

The dollar, as a gauge of investor fear, added 0.5%, making dollar denominated assets including many raw materials less competitive as exports.

Oil prices fell 1%, for West Texas Intermediate and Brent, and some farm commodities dropped even more.

Nine-month low

Notably cotton, which followed up its close to the last session down the maximum allowed in New York by touching limit down again, for October delivery, and hitting the lowest for a spot contract since October before recovering some ground,

The October lot stood 4.2% lower at 106.90 cents a pound at 07:40 GMT (08:40 UK time). The better-traded December lot was 4.2% lower at 104.30 cents a pound

While Australia & New Zealand Bank noted a "lack of end-user demand", cotton is often among the most sensitive farm commodities to macro-economic concerns – being, as a non-food crop, more in the way of a luxury than a necessity, and more sensitive to discretionary spending.

A further tumble in prices on China's Zehngzhou exchange added extra jitters, with the best-traded January lot sliding 4.8%. China is the top grower, consumer and importer of the fibre (of which the US is the top exporter).

Condition improves

And, as in the last session, wheat scored large on the loser board too, down 2.2% to $6.25 ½ a bushel for Chicago's best-traded September lot.

Harvest pressure was one reason, with combines well underway on grains harvests in the Black Sea and southern Europe, besides in the US (where nearly two-thirds of winter wheat is in silos).

As of Monday, Ukraine farmers had reaped 5.6m tonnes of grains with an average yield of 2.86 tonnes per hectare, up from 2.43 tonnes per hectare a year before, news agency Interfax said.

The better condition of the US spring crop was another, with 73% rated in "good" or "excellent" health as of Sunday, up three points week on week, and closing the gap with the year-before performance, when 83% was rated in the top two grades.

Minneapolis spring wheat was 2.0% lower at $7.78 ¾ a bushel for September delivery.

'Russian prices setting the tone'

And that is before getting to the competition factor, and Russia's return to exports.

"Wheat is at the mercy of world prices right now, and Russian wheat prices are setting the tone, as they are the cheapest in the world," Mike Mawdsley at Market 1 said.

At Benson Quinn Commodities, Brian Henry said: "Russia continues to offer 11.5% milling wheat at $240.00 a tonne. This is basically $30-35 cheaper than offers from the European Union and US.

"Russia will likely continue to offer wheat at these lower prices unless Ukraine begins to offer milling wheat. To this point, they have only been offering feed wheat."

Weather factor

Corn felt the pressure from wheat, an alternative in many uses. (Indeed, rail-to-ethanol group The Andersons confirmed on Monday that it has started mixing wheat in with corn in making the biofuel.)

Still, with the prospect of hot US weather providing some support, corn's fall was limited to 1.1% to $6.36 ¼ a bushel, for Chicago's September contract, and by 1.0% to $6.26 ½ a bushel for December.

Soybeans, once again, performed best of Chicago's big three, if still falling, by 0.7% to $13.37 ¾ a bushel for August and by 0.7% to $13.37 a bushel for the new crop November contract.

The oilseed is also getting some support from the weather, as well as from the prospect later of the US Department of Agriculture's monthly Wasde report cutting forecasts for domestic soybean inventories following a downgrade two weeks ago to sowings estimates.

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Cattle market in US to face 'explosive situation'

by Agrimoney.com

The dry weather in the South has set up the US for a "potentially explosive situation" in cattle markets – although only after sapping prospects for the current rally in prices.

US beef cow slaughter topped 75,000 head in the week to June 26, the latest data available, the highest total of 2011 - and in a period when liquidation typically shows a small decline.

The rise has been attributed by some analysts to strong demand, with the July 4 weekend typically seen as a peak in America's barbecue season.

"We are seeing demand picking up from a lot of packers," said Drax Wedermeyer at US Commodities, which estimated beef processors' margins topping a "large" $55 a head in mid-June, amid the slaughter spike.

Margins had fallen back to below $30 a head by the end of last week.

'Simply not enough grass'

However, "one of the most severe droughts in years" in many parts of a swathe of America from Arizona in the west to Maryland in the east may also be encouraging farmers to accept strong prices for cattle, two leading analysts said.

"There is simply not enough grass to support cow herds," Steve Meyer and Len Steiner said.

Official data overnight showed US pasture rated on average as 49% in "good" or "excellent" condition, compared with 65% a year before.

In Texas, where 86% of pasture was in "poor" or "very poor" health, "some livestock problems were encountered with cattle drinking high salinity water from wells and windmills", the US Department of Agriculture said.

With hay expensive too, "many cattlemen simply do not have the necessary resources to hang on", Dr Meyer and Mr Steiner said.

'Must be a reckoning'

The dent to breeding stock, at a time when the US herd is already at among its lowest levels in decades, looks set to dent future supplies – and lift prices.

"There must be a reckoning," the analysts said.

"The number of available calves must fall, setting up a potentially explosive situation for calf prices and, eventually, for feed cattle, fed cattle and beef."

Short-term blip?

However, it could curtail in the short-term the rise in prices of feeder cattle, those ready for fattening, if ranchers are opting to place stock in feedlots as well as take them to slaughter.

"It now appears that the drought and high fertilizer prices have reduced available grass pastures enough to push more cattle, even some spring calves, into yards.

"Our contacts tell us to not be surprised to see June placements [of feeder cattle on feedlots] at or above year-ago levels and easily high enough to keep feedlot inventories above year-ago levels.

"That would suggest higher live cattle numbers, year-on-year, through the end of this year."

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Europe banks hit as Italy stokes contagion fears

By Steve Slater and Ian Simpson

(Reuters) - European banks were battered by mounting fears Greece is heading for a disorderly default and the debt crisis could spread to Italy, sending shares skidding more than 3 percent Tuesday to a two-year low.

Early losses were pared after Italy successfully sold short-term bonds and the panic eased. But bank stocks were still on the defensive and down over 10 percent in the last seven trading days as politicians have failed to find a fix for Greece and as investors fear this week's health check on 91 banks could show up more holes in the industry.

Euro zone finance ministers Tuesday said a flexible rescue fund to help Greece could buy back its debt, but they set no deadline to act and failed to calm investor nerves. They also declined to rule out the possibility of a selective default by Greece to make its debt mountain more sustainable.

"Things are clearly going from bad to worse. It took too long to stabilize Greece and now the contagion is spreading. There is certainly a fundamental element in the worries about Italy. The debt load is high and growth is lackluster," said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets in Brussels.

By 0923 GMT the STOXX Europe 600 bank index .SX7P was down 1.1 percent at 172.6, after falling as low as 168.02, its lowest level since May 2009.

Italian bank Unicredit (CRDI.MI) fell over 7 percent and Intesa Sanpaolo (ISP.MI) lost 4 percent, before turning higher aided by a short-selling ban by Italy's regulator and news Italy had sold its targeted 6.75 billion euros of 12-month bills in a bond auction. By 0955 GMT Unicredit and Intesa were each up 2 percent.

Unicredit shares are still down by a fifth since July 1 as borrowing costs for Italy have soared on fears about the scale of the country's debt.

Alessandro Frigerio, fund manager at Milan's RMJ Sgr, said the recovery was helped after Economy Minister Giulio Tremonti said he would wrap up an austerity package.

"Finding a solution is tough, but the markets are saying in a tough situation you have to take the devil by the horns... Right now we're in a phase that is not manageable anymore because Italy right now, when it goes to the market, has to pay 6 percent (in 10-year bonds) and that's a very, very difficult level," Frigerio said.

Andrew Lim, analyst at Espirito Santo in London, added. "Italy and Spain have been thrown into the mix and they are far bigger in magnitude than Greece, Ireland and Portugal. This could be a true systemic crisis. This is a very real threat and the panic feeds on itself."

As borrowing costs rise, the repayment of debt becomes more costly to maintain and could lead to an economic slowdown and more losses for banks.

Barclays (BARC.L), BNP Paribas (BNPP.PA), Deutsche Bank (DBKGn.DE), Lloyds (LLOY.L), UBS (UBSN.VX) and Credit Agricole (CAGR.PA) all fell over 2 percent.

In Portugal banks also reversed steep early losses and were up over 1 percent in volatile trade. Shares in the country's largest listed bank Millennium bcp (BCP.LS) were up 1.2 percent on the day at 0.33 euros after a near 6 percent slump in early trade down to record lows of 0.305 euros.

Euro zone finance ministers Monday promised cheaper loans, longer maturities and a more flexible rescue fund to help Greece and other EU debtors in a bid to stop financial contagion engulfing Italy and Spain, but there are fears the rescue effort is unraveling. They will continue their meeting Tuesday.

"They could have taken care of this a year ago, a month ago or a week ago. They didn't and now it's spreading to other markets," said Oon-Marc Valahu, a fund manager at Geneva-based firm ClairInvest.

The market fall could continue as long as uncertainty remained over how Europe's politicians would deal with the debt crisis, he said. "The market hates instability and you can't stop the market from going down on fear."

The Institute of International Finance, which is leading talks on a private sector contribution to Greece's rescue, wants the EU to pledge to buy back debt to provide a longer term solution to Greece's mountain of debt, rather than just a quick fix.

The release of the result of a stress test on European banks is another worry. It could show holes in the capital position of some banks and analysts said another fear is that a weak test could fail to restore confidence.

"We've got the solvency tests being released Friday, which is why everyone's a bit nervous. The market is short the banks, which has been an easy trade," said Andrew King, head of equities at BNP Paribas Asset Management, which has 551 billion euros in assets under management.

SPANISH FAILURES?

Some Spanish banks could fail the stress tests, Spain's Economy Minister Elena Salgado said Monday, backtracking from earlier comments that all Spanish banks would pass. This year's test will not include generic provisions -- funds set aside during good times to provide a buffer in bad times -- which will hurt Spanish lenders as they had 27 billion euros of generic provisioning at the end of March.

Six Spanish banks have failed the European stress tests, including five savings banks and one medium-sized bank, ABC newspaper said Tuesday, citing unnamed sources. The Bank of Spain declined to comment.

"It depends who has failed -- it would have to be one of the medium-sized listed banks to have a big shake on the sector. Smaller savings banks failing would have less of an impact," said Tania Gold, analyst at UniCredit.

The impact of problems in Italy would be felt more widely. Overseas banks had $1.1 trillion of exposure to Italy at the end of December, with France's banks accounted for $389 billion of that, or 35 percent, according to data from the Bank for International Settlements.

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Navigating the Road to Riches

by Otaviano Canuto

A switchover of global growth engines is taking place. Developing economies as a whole are now the source of more than half of global GDP growth. As a result, concern has naturally shifted to a new question: Are there risks that some or many of these developing countries could fall prey to the “middle-income trap”?

The “middle-income trap” has captured many developing countries: they succeeded in evolving from low per capita income levels, but then appeared to stall, losing momentum along the route toward the higher income levels of advanced economies. Such a trap may well characterize the experience of most of Latin America since the 1980’s, and in recent years, middle-income countries elsewhere have expressed fears that they could follow a similar path. Does moving up the income ladder get harder the higher one climbs?

In most cases of successful evolution from low- to middle-income status, the underlying development process is broadly similar. Typically, there is a large pool of unskilled labor that is transferred from subsistence-level occupations to more modern manufacturing or service activities that do not require much upgrading of these workers’ skills, but nonetheless employ higher levels of capital and embedded technology.

The associated technology is available from richer countries and easy to adapt to local circumstances. The gross effect of such a transfer – usually occurring in tandem with urbanization – is a substantial increase in “total factor productivity,” leading to GDP growth that goes beyond what can be explained by the expansion of labor, capital, and other physical factors of production.

Reaping the gains from such “low-hanging fruit” in terms of growth opportunities sooner or later faces limits, after which growth may slow, trapping the economy at middle-income levels. The turning point in this transition occurs either when the pool of transferrable unskilled labor is exhausted, or, in some cases, when the expansion of labor-absorbing modern activities peaks before the pool is empty.

Beyond this point, raising total factor productivity and maintaining rapid GDP growth depends on an economy’s ability to move up on manufacturing, service, or agriculture value chains, toward activities requiring technological sophistication, high-quality human capital, and intangible assets such as design and organizational capabilities. Furthermore, an institutional setting supportive of innovation and complex chains of market transactions is essential.

Instead of mastering existing standardized technologies, the challenge becomes the creation of domestic capabilities and institutions, which cannot be simply bought or copied from abroad. Provision of education and appropriate infrastructure is a minimum condition.

Today’s middle-income countries in Latin America saw the transfer of labor from subsistence-level employment slow well before they had exhausted their labor surpluses, as macroeconomic mismanagement and an inward-looking orientation until the 1990’s established early limits to that labor-transfer process. Nevertheless, some enclaves have been established in high positions on global value chains (for example, Brazil’s technology-intensive agriculture, sophisticated deep-sea oil-drilling capabilities, and aircraft industry).

By contrast, Asian developing countries have relied extensively on international trade to accelerate their labor transfer by inserting themselves into the labor-intensive segments of global value chains. This has been facilitated by advances in information and communication technologies, and by decreasing transport costs and lower international trade barriers.

The path from low to middle income per capita, and then to high-income status, corresponds to the increase in the share of the population that has moved from subsistence activities to simple modern tasks, and then to sophisticated ones. International trade has opened that path, but institutional change, high-quality education, and local creation of intangible assets are also essential for sustaining progress over the long run. South Korea is a prime example of a country that exploited these opportunities to move all the way up the income ladder.

As for maintaining high growth in developing countries, the remaining pool of rural-subsistence and urban-underemployed labor in low- and middle-income countries constitutes a still-untapped source for increases in total factor productivity via occupational change. For this to succeed at the global level, middle-income countries that have already started the process must overcome the obstacles on the road to higher income, thereby creating demand and opening supply opportunities for the primary labor transfer in developing countries farther down the income ladder.

Natural-resource-rich middle-income countries face a road of their own, one made wider by the apparent long-term increase in commodities prices that has accompanied the shifts in composition of global GDP. Unlike manufacturing, natural-resource use is to a large extent idiosyncratic, which creates scope for local creation of capabilities in sophisticated upstream activities, with the corresponding challenge to do so in a sustainable fashion.

While most country that evolve from low- to middle-income status have followed a fairly common route, their next stages point to a more diverse set of experiences in terms of institutional change and accumulation of intangible assets. Given advanced economies’ poor growth prospects, the world economy’s dynamics nowadays will depend on how successful country-specific steps up the income ladder turn out to be.

Otaviano Canuto, the World Bank’s Vice-President for Poverty Reduction and Economic Management, is co-author of The Day After Tomorrow: A Handbook on the Future of Economic Policy in the Developing World, available at www.worldbank.org/prem.

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Bank Exposure to Domestic Sovereigns

By Global Macro Monitor

Here at the Global Macro Monitor we perceive a rapidly changing financial landscape. The concept of risk-free is being redefined as we write and analysts are now forced to look at the systemic risk caused by a banking system’s exposure to their domestic sovereign. This, not in Ecuador, but now in the core of Western Europe!

The BIS released a report today that included the following chart, which we thought was very interesting and relevant to today’s market. It measures the percentage of equity capital each country’s banking system is exposed to the domestic sovereign. Italy’s banks, for example, have more than 60 percent of their equity exposed to the government, which partially explains how the sovereign finances such a large portion of its deficits internally.

As the perceived credit risk of the Italian government increases, however, the banks, who are highly exposed, will likely reduce their holdings and willingness to purchase new bonds or debt, thus leading to a potential domestic buyers strike. This is how a downward spiral develops, which, if not aggressively addressed can lead to a sovereign funding crisis. The feedback between the financial sector and the sovereign further complicates the policy response. Reuters writes,

But while a wide range of investors had sold bonds, the major driver behind the moves was a lack of domestic Italian institutions willing to buy the paper on offer forcing banks to mark their prices lower, traders said.

“What we’ve seen in the crisis so far when we have the big widening moves is the Italian domestics come in. we’ve seen an absence of them in the last week and reduced activity for the two weeks before that,” said Justin Knight, head of European rates strategy at UBS in London. Domestic demand could be shrinking due to a number of technical factors, analysts said.

The same is true with Japan. However, Japanese banks’ exposure to the government is in a different universe and is illustrated on the right axis. Now can you guess who has been financing Japan’s massive fiscal deficits?

Let’s hope our leaders in Washington have their “Sputnik moment” very soon as they watch Europe come unraveled over fiscal and debt mismanagement. Is it possible both parties can have an epiphany about the current fragility of market confidence in highly indebted sovereign borrowers and how difficult it is to regain that confidence? In the next 11 days and with a sub-3 percent 10-year bond yield?

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Let the government to Merkel

Nella giornata più nera dell’economia italiana nell’ultimo ventennio, per fortuna, non si è udita la voce del capo del governo. Ha parlato per noi la Merkel, capo del governo tedesco, e di ciò la ringraziamo. Ma dobbiamo ringraziare altrettanto Silvio Berlusconi per avere intuito che non era giornata per futili esternazioni. Il suo silenzio quantifica l’autorevolezza e la credibilità di cui dispone.

Why the U.S. Should Return to the Gold Standard – Even Though it Won't

By David Zeiler

Should the U.S. return to the gold standard?

It's a question that has taken on new relevance during a time of soaring deficits and sky-high national debt.

Many of the world's most successful governments, from ancient Rome to the British Empire, enjoyed centuries of economic stability by adhering to a gold standard. And some economists credit the period of prosperity at the end of the 19th century to a global gold standard.

"The period of 1870 to 1914 recorded the highest real growth rates worldwide and was

among the most peaceful ones in history," says a report on gold released earlier this month

by European bank Erste Group. "Most of the budgets were balanced, and there was a free flow of capital across borders. The only job of the central banks was to exchange gold for paper or vice versa."

Even former Federal Reserve Chairman Alan Greenspan has noted the historical benefits of the gold standard.

"Some mechanism has got to be in place that restricts the amount of money which is produced, either a gold standard or a currency board, because unless you do that all of history suggest that inflation will take hold with very deleterious effects on economic activity," Greenspan told Fox Business News in January. "There are numbers of us, myself included, who strongly believe that we did very well in the 1870 to 1914 period with an international gold standard."

Money Morning Contributing Editor Martin Hutchinson agrees, and he is one of a growing number that believe the U.S. should return to the gold standard - even though he sees such a drastic change as unlikely.

"It would solve the unemployment problem, because expensive capital makes people use more labor," said Hutchinson. "And it would indeed enforce fiscal discipline."

Hutchinson concedes that such a drastic action would indeed have negative consequences, as well - but the long-term benefits of stability would be preferable.

"Stock markets would crash, bonds I'm not sure, because investors currently are relying on inflation to solve the U.S. debt problem," he said. "It could become dangerously deflationary."

Indeed, Hutchinson and others believe the United States should return to the gold standard to reverse years of U.S. Federal Reserve policies that have eroded the value of the dollar.

Still, that could be better than the alternative, which is watching the U.S. and other governments around the world attempt to print their way out of economic ruin.

An Inconvenient Solution

Many analysts fear that the Fed's policy of pouring $2.3 trillion into the economy in an attempt to spur growth is really only fostering inflation and devaluing the dollar - with potentially disastrous consequences.

Fixing the value of the dollar to gold would mean more money could not be printed unless more gold was obtained to back it up. Historically, economies using a gold standard currency enjoy stable prices - governments can't print the excess money that causes inflation - and governments without excess money can't spend themselves into massive debt.

That's why many local activists and legislatures are pushing for a return to the gold standard.

Social conservative group American Principles in Action joined forces with the Iowa Tea Party in June to set up a "Gold Standard 2012" bus tour that included appearances by several Republican presidential contenders.

Also last month, three Republican senators introduced a bill to Congress, the Sound Money Promotion Act, which would make it easier to use gold and silver coins as currency. Utah has gone even further - its Legal Tender Act of 2011 makes it possible to use gold and silver as cash, but with the value based on weight.

"Fiat currencies are frequently manipulated in such a way to finance the large-scale expansion of national governments," Sen. Mike Lee, R-UT, told Smart Money. "The expanded discussion about the need for at least the option of precious metal currency systems is because of that fear."

The world went off the gold standard in 1914 because the powers of Europe needed to print more money than the gold standard would allow in order to pay for World War I.

The gold standard reappeared just after World War II as part of the Bretton Woods agreement. The idea was to avoid the international monetary chaos of the interwar period, particularly the Great Depression, by tying currency to gold.

Unfortunately, only the U.S. dollar was actually convertible to gold; other currencies were pegged to the dollar. The system relied upon the U.S. government acting in a fiscally responsible manner.

"That wasn't a gold standard," Money Morning'sHutchinson said of Bretton Woods. "That was fiat money dressed up as a gold standard."

The large costs of the Vietnam War and President Lyndon Johnson's Great Society created such stresses on the U.S. monetary system that President Richard Nixon was forced to drop the gold standard in 1971.

So while history illustrates the benefits of the gold standard, it also illustrates why it has so often been left behind - ravenous government budgets, particularly when that hunger is fed by an emergency like war or economic distress.

Since the United States has both now, it would seem extremely unlikely that Washington lawmakers will agree to a return to the gold standard any time soon.

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What's In Store for Tomorrow's USDA Report

By: Kevin Van Trump

I believe there is still one piece of bearish data looming that has a few bulls still on the sideline, and that is the USDA report scheduled for release tomorrow morning before the open. With the last USDA report delivering a Mike Tyson like uppercut to those who were long, very few "bullish" traders are willing yet to step back into the ring, fearing a possible repeat performance could be in the cards. Once the report is behind us, I would suspect those counting cards will see the deck being stacked with more "bullish" possibilities rather than "bearish." After the latest round of USDA data is digested the trade will immediately start to focus on weather, yields, and the results of a "re-survey." I like buying the breaks, and believe we might get an opportunity over the next couple of days to see another push lower. Remember, a serious "weather" play will happen in the blink of an eye. It will not continually give you opportunities like a "demand" type play. If you are wanting to make the play, I urge you to be extremely cautious. Look to use "calls" or other types of bullish strategies that provide you with "limited-risk" or downside exposure in case the weather card never hits the table. Look for the weight of the "outside" markets to continue to add pressure through the first half of this week.

 

Tomorrow's USDA Numbers

 

I wanted to give you quick guide to what most in the trade will be looking for in tomorrow's report that is scheduled for release at 7:30am CST. Hope this helps give you a better idea.

• I am hearing several analyst suggest that corn ending stocks for both 2011 and 2012 will be raised substantially. Remember, the USDA was at 730 million bushels for 2011 in their last report, and 695 million bushels for 2012. There are guys talking that the numbers could now be closer to 1 billion bushels... I am hearing a few trusted sources throwing out more realistic numbers in the low to mid 800 million bushel range for 2011, and lower to upper 900's for 2012. It will certainly be interesting to see how much more corn is now being estimated than just a few weeks back. Most are thinking they will add 175 million bushels to 2011, and up to 300 million bushels in 2012.
• Most are under the belief that the USDA is going to raise their 2011 soybean ending stocks from their recent 180 million bushel estimate. I have heard numbers anywhere from 190 million upwards to 220 million. My best guess is we see something right around 200 million bushels, on thoughts that several cargoes of Chinese purchases will be rolled forward or possibly even canceled. On the flip side you have to believe the USDA could actually reduce their 2012 number on thoughts of fewer acreage and increased exports. In their most recent report they had the 2012 ending stocks estimated at 190 million bushels. I am hearing talks ranging substantially lower for 2012, and a number closer to 160 million bushels would not surprise me.
• Another interesting number out tomorrow will be US spring wheat production estimates. Remember, last years crop was estimated at 616 million bushels, this time around most are thinking we will see a number between 540 and 550 million bushels.
• Look for the USDA to raise their 2011 wheat ending stocks number from 687 million bushels up closer to 700 million bushels despite the reduction in Spring wheat.

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Heatwave concerns overshadow key US crop report

by Agrimoney.com

Fears for a heatwave could yet underpin corn prices even if US officials, in a much-anticipated report, hike estimates for domestic inventories near to the psychologically important 1bn-bushel mark.

Orthodox thinking suggests that Tuesday's US Department of Agriculture Wasde report, detailing estimates for world crop supply and demand, will usher in a period of weaker prices "heading into harvest" this autumn, Drax Wedermeyer at US Commodities said.

"It is expected to be a bearish report because of the increased acres," he said, after the USDA two weeks ago hiked its forecast for corn sowings, besides finding more stocks left over from the last harvest than had been expected.

The consensus forecast is for the USDA to lift its estimate for America's corn inventories by 175m bushels to 905m bushels at the close of current season.

For the close of 2011-12, analysts on average expect a 300m-bushel rise to 994m bushels in the stocks estimate, although many expect a higher figure.

"It's not difficult to get above 1bn bushels, and then in a sneeze you have doubled the carryout," Mike Mawdsley at broker Market 1 said.

Heat dome

However, the report is being overshadowed by a heatwave which has already hit crops in southern states, sending the proportion of crops rated "good" or "excellent" in Texas, as of Sunday, standing at 13%, down by four points over the previous week.

Forecasts for Wasde estimates for US corn and (current estimate) End 2010-11 stocks: 905m bushels, (730m bushels) Lowest estimate: 805m bushels Highest estimate: 1.05bn bushels End 2011-12 stocks: 994m bushels, (695m bushels) Lowest estimate: 757m bushels Highest estimate: 1.18bn bushels

"The development of a powerful 'heat dome' continues to appear in all the models on the Monday morning weather models," weather service WxRisk.com said.

"The dome develops around July 15 and spreads into the western Corn Belt on July 16," where it may last at least until July 21-22, and potentially for more than a week – in the sensitive corn pollination period.

"We haven't had a real, heavy duty heatwave in pollination for a few years, since 2005," Jerry Gidel at broker North America Risk Management Services said.

"If the [Wasde] corn stocks number comes in close to 1bn bushels, where people are expecting it, people could move onto focusing on the weather pretty quickly."

'Issues in finding physical corn'

With concerns that heavy rains have leached away some nitrogen fertilizer in areas such as Iowa and southern Illinois too, Matthew Pierce at PitGuru highlighted the spread in yield estimates, around the USDA's current estimate of 158.7 bushels per acre.

Forecasts for Wasde estimates for US soybeans and (current estimate) End 2010-11 stocks: 198m bushels, (180m bushels) Lowest estimate: 180m bushels Highest estimate: 220m bushels End 2011-12 stocks: 169m bushels, (190m bushels) Lowest estimate: 134m bushels Highest estimate: 197m bushels

"I've heard some estimates in the low 150s and some in the low 160s," he said. Informa Economics on Friday pegged the US corn yield at 162.5 bushels per acre.

Market 1's Mike Mawdsley added the crop forecasting signals were "about as confusing as we have ever seen in the middle of the summer", noting also the USDA's higher-than-expected corn inventory number.

"There are issues in finding physical corn, especially on the fringes, whatever the figures say," Mr Mawdsley told Agrimoney.com.

"In Indiana, they are offering $0.50-0.60 a bushel over Chicago, and might still not get corn. Our guy in Texas has supplies running out soon."

Export hit

The Wasde is expected to show the official estimate for US soybean stocks at the close of 2010-11 lifted by 18m bushels to 198m bushels, following a sluggish pace to exports.

Forecasts for Wasde estimates for US wheat and (current estimate) End 2011-12 stocks: 702m bushels, (687m bushels) Lowest estimate: 650m bushels Highest estimate: 761m bushels 2011-12 production: 2.071bn bushels, (2.058bn bushels) Lowest estimate: 1.990bn bushels Highest estimate: 2.138bn bushels

Export inspection data on Monday showed 4.5m bushels of US soybeans shipped during the first week of July, down one-third from the same period a year ago.

However, the forecast for inventories at the close of 2011-12 is expected to be cut by 21m bushels to 190m bushels, following a lower USDA estimate for sowings, attributed in part to farmers opting for corn instead.

For wheat, the production figure is likely to capture attention, with analysts expecting the data to forecast a drop in US spring wheat production to a three-year low of 551m bushels.

But total wheat production is seen coming in at 2.07bn bushels, up 13m bushels on the USDA's last figure, after harvest results showed the hard red winter wheat crop which has been less affected by dry weather than had been feared.

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