FYI | Dec 07 2010
By Greg Peel
While immediate problems in Europe seem to have settled down somewhat in the wake of the Irish bail-out, concerns have persisted that were a bigger economy to hit the skids the existing EU-IMF bail-out fund of around E750bn would not be enough to prevent defaults. Already Portugal is looking at market-imposed credit spreads that would make bond rollovers to a higher interest cost untenable, and fear lingers of the domino effect into Spain and even Italy.
To recap, there are 27 nations in the European Union but only sixteen of them have adopted the common currency of the euro. Notable exceptions are the large economies of the UK and Sweden. Of those nations within the eurozone there is a fairly distinctive split between the northern economic powerhouses of Germany, France and their smaller neighbours and the southern economic basket cases of Greece, Portugal and Spain in particular. Any strength in the euro can be attributed to the north – and in particular the hard-working and frugal Germans – allowing the less productive southern states to ride on the north's coat tails and abuse and exploit the strength of their common currency.
The south includes Greece, where it has been revealed, for example, that tax avoidance is the national pass time, and Spain, which has suffered a catastrophic property bubble-and-bust, but also Italy, which despite being the world's seventh largest economy has managed to be overly profligate in its euro exploitation. Then of course there's Ireland, which has also seen a property bubble-and-bust but has suffered from shying away in the 21st century from traditional industries and trying to become a European banking centre instead.
One of the biggest problems of the eurozone structure is that while there is a common currency there is no common bond. In the US, for example, there is one currency and one bond and a QE program which involves printing currency to buy those bonds. In the eurozone there is one currency but sixteen individual sovereign bonds. While PIIGS bond yields blow out money rushes into the safety of German bonds causing an imbalance which cannot be reflected by exchange rate movements given the single currency. The end result is Germany has to feed taxpayer funds back into the PIIGS to prevent the collapse of the euro – much to the chagrin of frugal Germans.
Were there never a euro created and instead the EU existed with each member retaining its original and individual currency, then exchange rate movements would reflect the respective size and strength of each economy. Southern Europe would find itself with much less spending power and opportunity to live the high life. Germany's currency would be the strongest.
While it may seem an obvious solution to simply ditch the euro as a nice idea proven unworkable, so much European finance is tied up in the common currency the fall-out of attempts to unravel the web would still be itself catastrophic, according to analysts. But it must also be noted that while Germany might bitch and moan about its profligate co-members, its own export economy has received a considerable boost from the euro's value reflecting the smaller economies in the mix as well as the larger – even before the debt problems began to surface.
There is a lot of outcry about China's “artificial” currency but in truth, Germany is also benefiting from something “artificial”.
Since the Greek crisis early this year the European Central Bank has been forced to extend cheap emergency loans to European banks and to buy up the distressed bonds of the PIIGS. As the crisis had appeared to abate in the wake of the Greek bail-out and the establishment of the E750bn EU-IMF general emergency fund, the ECB had begun quietly reversing those measures. Since Ireland blew up however, the ECB's back at it again.
So not only are Germany and others contributing taxpayer money to EU emergency bail-out funds, they are by default contributors to ECB funding as well which is currently being used to buy distressed PIIGS debt. It's no wonder that in its death throes, the Brown government initially rejected any idea of a UK contribution to a eurozone fund. The pound had its own problems.
So the eurozone is stuck with the euro for now and all rhetoric suggests that's the way the EU members want to keep it. This is despite Germany making moves to reintroduce trading in the Deutschmark alongside the euro. What is said in back rooms is clearly different to that said in public. But as Ireland becomes the next member threatening to start of the domino effect of default into Portugal, Spain and maybe even Italy there is now fear that the E750bn bail-out fund simply may not be enough.
To that end the eurozone finance minsters have been meeting this morning (Sydney time) to discuss the issue. The head of the IMF has suggested that the emergency fund needs to be increased in size. That's one option to consider.
Another option, as put forward by Italy's finance minister along with the prime minister of Luxembourg, is for a common eurozone bond to be created as well as the common currency to deliver a “strong and systematic response to the crisis”.
At present, money is flowing out of the sovereign bonds of the PIIGS members and into German bonds in particular, creating the imbalance a single currency can't adjust for. European debt has become the plaything of global traders and the blow-outs in yields on PIIGS bonds potentially mean that no matter what levels of budgetary austerity are imposed, the cost of rolling over debt when its due will be so much higher as to render it unpayable anyway. Default should surely follow.
The theory is that a common bond would address this imbalance. But Germany has already voiced its complete disapproval ahead of the meeting – both for the common bond idea and for the IMF's suggestion of more emergency funds. Mind you, Germany was always dead against the original emergency fund from the outset but finally capitulated once the Merkel government had assured support from its Opposition.
The other rumour that went around markets last week was that the Fed would step into the fray and indirectly contribute to the eurozone emergency fund by providing more funds to the IMF. The US is already the IMF's biggest contributor and maintains a strong control over the “global” body. We know that the Fed can create funds out of thin air, given that's exactly what QE2's all about (and QE1, and probably QE3).
Why would the US want to help Europe? Well because of the flow-on effect of a European collapse to all global financial markets. Just as the GFC threatened to bring down America and thus the rest of the world in the process. Of course, the idea of the US helping Europe raises the hackles of the ignorant, jingoistic and self-serving members of US Congress who can't get past “America the superpower” because they still don't understand the GFC nor the reasons it occurred.
Another solution to the crisis, expressed back when Greece was the centre of attention, is to simply allow members to default on their debt just as Russia did in the late nineties. Russia is now back stronger than ever. The problem here is that those holding PIIGS bond do not just include US hedge funds but mostly many banks across Europe which would be driven insolvent by their resultant losses.
Okay – how about PIIGS bondholders simply take a “haircut” on their investments? This means that instead of receiving 100 cents in the dollar on maturity to agree to take a lesser amount. This would effectively reduce borrowing costs for the PIIGS and if implemented carefully would dilute the fall-out and maintain the solvency of European banks. Indeed, there are plenty in the market now assuming haircuts are inevitable.
But such a move would, in reality, mean the euro experiment has been a failure. The structure of the eurozone would not have held together as intended and the euro itself would be seen as pretender rather than a legitimate alternative to the US dollar as global reserve currency. At least in public, EU members do not want this to happen.
So what's the upshot of all of the above? Uncertainty. And financial markets fear uncertainty over everything else, including an obvious bear market. At least you know where you're going in a bear market and can make investment decisions accordingly. If you have no idea what might happen next, you simply stay out of it. Or buy gold.
Realistically there are three main macro factors driving and worrying global financial markets at present. One is the strength or lack thereof of the US economy, but that is supposedly now covered by QE2. Another is the potential for further Chinese monetary policy tightening measures, but realistically Beijing only tightens when China's economy threatens to run too hard.
And the third is Europe, which quite simply is an unknown.
