FYI | Dec 09 2009
By Greg Peel
The European Union was created out of the old Common Market model with the intention of pulling a collection of old foes into a trading bloc which could compete more effectively with the world’s largest economies of the US and Japan (and more recently by default, China).
While the EU pulls together economic stalwarts such as Germany, France, the UK and Italy, it also must deal with a bunch of lesser contributors. Moreover, fringe-dwelling Europeans including those of the Eastern Bloc quickly realised that to not be in the EU was to be even more economically isolated than previously, so there has been an ongoing battle to get in as soon as possible which has seen membership increase several-fold. Even Turkey wants in (I suppose courtesy of that little bit west of the Bosporus). And Iceland clearly made a big mistake in not being in. There are currently 27 members, from big Germany down to little Malta, and including nine former Eastern Europeans.
In 2007, the EU just pipped the US for total GDP. In 2008, it just fell short.
Further unification was achieved this century with the introduction of a common EU currency in the euro. However, euro participation is optional, and as such only 16 of the 27 member states have opted in. Two big economies in the UK and Sweden have elected to retain their own currencies, while the remainder of the non-euros are mostly former Eastern Europeans.
This leaves what is known as the “Euro Zone” as Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, and Spain.
The Eurozone’s biggest complication is that there is no such thing as an EU bond. As we speak, the US Treasury is madly issuing sovereign bonds to attract creditors to pay for its deficit. The Fed has just wound up its quantitative easing program in which it has also bought Treasury bonds to provide inflationary support. The Bank of England is still buying UK bonds, and likewise the Bank of Japan. Australia has begun reisssuing Aussie bonds in earnest after a long hiatus during the period of fiscal surpluses.
But the EU, as a bloc, has no bond. Instead, each euro member country is responsible for its own bond issuance (euro-denominated) under the watchful eye of the European Central Bank. Were one state in particular to go mad with debt-issuance, it would have an incremental impact on the euro. On this basis, while the EU may be a trading bloc it is still an emulsion of disparate economies, not a blend. There is always a risk that emulsion will split, and thus always a certain fragility about the EU. And when the GFC hit late last year, the ECB could not leap into quantitative easing like its central bank counterparts. There was no bond to buy.
As an alternative measure, the ECB provided low-rate one-year loans to individual European banks so that each economy could attempt to prop itself up through on-lending into local credit markets. With the Greek economy in tatters, and political upheaval having led to a new socialist government forming only two months ago, Greece’s own sovereign bonds have blown out in yield to be 230 basis points above the benchmark German bond (bund) which is yielding around 3%. The ECB cash rate is currently 1.0%.
Rather than lending ECB funds to local corporates, Greek banks have been “carry trading” those funds and investing in high-yielding Greek sovereign bonds. It’s been money for jam. And each time the ECB announces more loans, Greek banks are first in to line up. Greece’s fiscal budget deficit is forecast to hit 12% of GDP in the current fiscal year, and total government debt (including the current account) is forecast to hit 130% of GDP next year. The ECB is soon to wind down its emergency loan program.
Last night the Fitch ratings agency downgraded Greece’s sovereign debt to BBB plus from A minus and placed a negative watch on the rating such that further downgrades may be forthcoming. On Monday Standard & Poor’s maintained its A minus rating on Greece but also put the country on negative watch. The implication here is that Greek debt loses value, and many global mutual funds have limits on what quality of debt they can invest in. For some, a BBB minus may mean time to sell out. Greece needs bond investors to provide the funds required to finance its deficits. Now it will have to pay a higher interest rate.
Greece is the first Western European state after Iceland (non-euro) and Ireland (euro) to drop below A minus.
First Dubai, now Greece. Loitering in the background are all those Eastern European states which have been struggling to survive the GFC. The implication globally is that the GFC is far from over and that sovereign debt defaults may yet white-ant apparent recovery. For Europe in particular, Greece’s downgrade has an impact on the euro just as the stronger economies of Germany and France are seeing light at the end of the tunnel. (Although one might note both those export nations have been angry lately about a too-strong euro).
The good news is that debt defaults among smaller nations globally are not coming as an unanticipated shock. The world’s large economies agreed in the GFC that the International Monetary Fund must be refinanced in readiness to provide emergency support. Hence the IMF has since issued its own multi-currency bonds (popular with China) and been given the green light to sell part of its extensive gold holdings (popular with India).
Once again, emerging markets are propping up the Old World. In Greece’s case, the Very Old World.
