FYI | Apr 29 2010
By Greg Peel
I've said it before and I'll say it again – it's beginning to look a lot like 2008. If Dubai is the subprime crisis of 2007, then Greece and its rescue are the Bear Stearns replica of early 2008, with the other PIIGS lining up like US investment banks. Which one is Lehman Bros? Spain? We'd want to hope it's not the UK.
The eurozone crisis has played out alarmingly similarly to the 2007-08 period. First came denial of a problem, then came an assumption of the end to the problem with one rescue, then came a growing sense of unease, a domino effect of liquidity fears and finally solvency issues, with Lehman being allowed to fold. Dubious accounting played an important role, as did relentless credit rating downgrades. Once on the slippery slope it's very hard to get off it.
As Danske Bank notes, such crises reverse the norm, in that lower prices (in this case sovereign bond prices) do not beget increased demand but instead beget further panic selling. One point at which our analogy breaks down is that the US Treasury and Fed cooked up a rescue package with JP Morgan for Bear Stearns in one weekend. The European situation has been exacerbated by constant dithering from EU politicians, providing mere motherhood statements and not specific bail-out details. As it stands, there is still no specific plan. We still don't know if Germany in particular, basically the JP Morgan in this case, can get its intention to save Greece through its own parliament. Suddenly, and long after sensibility would have suggested, there is panic from EU governments.
The warning signs were there when this time around, with the specific suggestion of a 45bn euro EU/IMF bail-out package being available, the market did not stop selling Greek bonds. By the time S&P downgraded them to junk they were already on the way. Portugal is now under seige with Spain looking nervous. The PIIGS (Portugal, Ireland, Italy, Greece, Spain) have a disquieting resemblance to GMMBL – Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, Lehman Bros.
The difference this time is there is no higher power. The remaining US investment banks were ultimately all bailed out by the US government in September 2008. The UK government had to all but nationalise its banking industry. The ECB fed emergency loans to European banks. The public sector saved the private sector, but unless SETI is on to something, who can bail out the public sector?
“We cannot underline enough how worried we are about the euro right now,” said the Danske Bank foreign exchange research team in a report this morning. Danske can see the situation from here playing out in one of three ways, which it calls (cue appropriate soundtrack) the good, the bad and the ugly. And even the good so not so great.
“The danger of contagion is that panic becomes self-fulfilling and hard to turn once it gets beyond a certain point,” notes Danske. “The implications of widespread contagion for the currency market could be profound and while the market is already more or less pricing in an expected debt restructuring in Greece (the illiquid market makes current prices hard to interpret) we suspect that the current risk premium on the euro does not yet fully factor in broad-based contagion.”
The market now suspects Greece is not simply suffering from liquidity issues but it is indeed insolvent. To restructure debt is avoid default by asking lenders to take a “haircut”, meaning some number of cents in the dollar rather than a full dollar on the debt's maturity. The alternative is potentially no cents. This is what a corporation would do, and what a stand-alone country with its own currency would do. This would not be without ramification but it would ensure at least some level of isolation. There is no isolation in a common currency. A Greek debt restructuring would lead to market to assume the same across all PIIGS, leading to a complete lack of confidence in the euro.
To date, notes Danske, the surplus Scandinavian countries Sweden and Norway (in the EU but not the eurozone) have seen their currencies hold up as peripheral safe havens and even the pound has seen relative support. Contagion would lead to all being sold off, along with the “risk” currencies (Aussie, Kiwi, Canadian dollar). Only the “safe havens” of the US dollar, the yen and the Swiss franc would benefit.
The good news is that Danske sees the “good” scenario as being most likely at this point.
In this scenario, the situation will likely turn worse before it gets better, but ultimately the EU politicians will look at Greece and see Lehman Bros. They will stop dithering and swing into action. Germany will resolve parliamentary resistance and make sure Greece rolls over its 8.5m euro of bonds coming due on May 19. May 9 is the German state election which, if lost by Angela Merkel's party, would mean a hung parliament. Greece would cope with domestic protests and make the required budget cuts.
Slowly the dust would settle, and contagion would be avoided. Sovereign debt markets would, very slowly, begin to normalise.
Then there's Danske's less likely “bad” scenario.
In this scenario, the reality of German parliamentary resistance, the 80% Greek bail-out disapproval rating among German voters, and the 65% resistance among Greek voters to further budget tightening measures plays out. Germany fiddles and Greece burns. Financial distress follows.
Greece has no choice but to restructure its debt triggering PIIGS contagion and the ECB is forced to start buying PIIGS bonds in defiance of its current constitution. There is rush to safe haven currencies, the euro plummets, the “risk” currencies dive, and we lose all of the momentum of 2009. Can China prevail a second time?
Danske sees the “ugly” scenario as least likely.
In this scenario the “bad” plays out but politicians simply lose control. The ECB is unable to stop the contagion. The euro is dumped for fear of a full collapse of the currency. Safe haven central banks are forced to intervene with money they don't have (but for safe haven inflows). We enter GFCII from a much more vulnerable starting point than we did GFCI. This time it's a lot worse.
As noted, Danske is assuming (praying?) the “good” scenario will prevail. This will still mean ongoing selling in the euro until an actual rescue is affected and the May 19 Greek rollover met, with sufficient plans in place to meet subsequent rollovers. The analysts have downgraded their one month euro forecast from US$1.34 to US$1.30 and their three month forecast from US$1.37 to US$1.27, but assume risk premium will finally decline later in 2010.
It would be foolish to assume Australia is immune from any of this, even though we came out of the GFC relatively unscathed against all immediate expectation. If the US dollar soars on euro weakness then commodity prices tumble. In late 2008 China started replenishing diminished commodity stockpiles but this time those stockpiles are more full than empty. While undeniably fast, China cannot build that many roads and apartment blocks in that space of time.
In the meantime, China, too, is providing global market weakness as the Shanghai stock market heads south again on monetary tightening concerns.
It's all up to the Germans at this point.
