FYI | Oct 20 2011
GaveKal offered the following observations this week: Since Axel Weber announced his resignation, we have been convinced that the Bundesbank was on the war path. And call us French, but belligerent Germans have always had a tendency to make us nervous. Meanwhile, nothing has happened since that day in February to make us believe that Europe was finding a solution to a problem it created on its own (we have argued since its inception that the Euro was a "solution looking for a problem" – unfortunately, it has now evolved to being a problem to which there is no solution!).
The current problem is simple enough: Europe has a hole of up to €1.5trn and every few weeks, European leaders gather to discuss how these sovereign losses should be apportioned. For France, the answer is that the losses should be borne by taxpayers (read Germany!) and muted through ECB debt monetization. For Germany, the bondholders must be made to suffer a lot more than they have so far and the taxpayer should be sheltered. Beyond this simple reality, it frankly seems to us that anything else is just noise. This includes all the hopes surrounding the idea of a levered €2trn EFSF:
* The first question this idea raises is who will provide the equity capital? Indeed, in its initial conception, the EFSF was supposed to be a private Luxembourg company which raised money by selling bonds (guaranteed by the European governments) to the likes of the GIC, Adia, CIC, BoJ etc… And these institutions did subscribe to EFSF bonds when Ireland tapped the vehicle in January, and again over the summer. Fast forward to today, with France's AAA rating under a shadow, and given the inability of European governments to agree to much, will these same institutions be as willing to buy into the equity tranche of a 4-1 levered junk-bond CDO for returns marginally above those delivered by Europe's better sovereign signatures?
* The second question, needless to say, is who will provide the leverage? Assuming that a consortium of Dexia, Societe Generale, Intesa, Santander, and Deutsche Bank together will not, right now, be able to provide the EFSF with €1.6trn in handy cash, then the fact is that only the ECB has that kind of fire-power.
These realities bring us back to the reasons why Germany is currently stalling so forcefully; Chancellor Merkel is well aware that a "levered EFSF" option really means that German taxpayers end up providing the equity capital while the ECB ends up providing the debt. This is exactly what Germany wanted to avoid: a situation where its taxpayers are on the hook and the bad debt is monetized away by the central bank. In other words, the worst of both worlds! Incidentally, when Charles tried his hand at retirement 12 years ago, "the worst of both worlds" is how his wife Chantal described having a retired husband-more husband and less money-so that only lasted for a year. Now granted, Chantal is undeniably stronger-willed and more forceful than Frau Merkel, but it is increasingly hard to see how the Chancellor will not get her way. Indeed, as Germany continues to stall, the pressure on France is now building (France having to ride to Dexia's rescue-see Daily-The Consequences of the Dexia Bailout, Moody's threatening a downgrade, etc…). And as France enters into its presidential electoral cycle, the options for President Sarkozy are shrinking rapidly. Thus, rather than resolution, we will likely see further slow-cooking of the French until they scream for mercy (and recap their banks?). It will only be once the crisis is in full force that the ECB will commit to the kind of debt monetization needed to save the technocrats' Euro dream. Until then, it is better to avoid owning assets in Europe and maintain a short-Euro position, if only as a hedge in portfolios. ??
The above expressed views are GaveKal's, not FNArena's (see our disclaimer). All copyright GaveKal.
GaveKal is a financial services firm that offers institutional investors and high net worth individuals fund management, independent research on global macro-economic trends and events, and independent advisory work on China and its impact on the global economy.
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