A Crisis that Never Goes Away: The Era of Rotating Sovereign Crisis
The crisis in Europe has wriggled its way back into the front pages after a lapse of about three months. Each time the European crisis gains prominence in the popular media, it comes with an increased intensity and an urgent need for policy makers to implement important changes. These changes need to be a combination of long-term structural changes and short-term in nature. Such a multi-pronged strategy if Europe is to avert a liquidity crisis from morphing into a solvency crisis, a direction in which EU is hurtling towards. It is remarkable that the policy makers either seem indifferent or completely unable to come to terms with the crisis. One should believe that it is the latter rather than the former cause that is leading to the prolonging of the crisis. An interesting characteristic of the crisis is that it has brought to the forefront
Sovereign Crisis:
As time flies by, more countries seems to be ready to join their peers in the insolvent list, albeit unofficial list. Greece was the first, with now Ireland joining the list. Portugal and probably Spain will join the list in the next year or so. Despite, the growing list of insolvent nations, not many seem to be willing to experiment with fundamentally more important solutions than those that have been time-tested (most of them without success). Increasingly, the two of the most important long-term problems on the global economic horizon are the problems in Europe and a slowing China. Both these are structural issues and importantly they have to be seen in conjunction with the continuation of the debt-deleveraging cycle in the USA, which should last at least another 3-5 years.
Amid much hope, EU announced a Euro 440 billion bailout fund which would be funded by members and guaranteed by all the members. Greece is expected to use about US$145 billion, while Ireland will need about US$113 billion while a bailout for Portugal will require about US$80-100 billion. Problems as well as structural contradictions will come to the fore once the crisis reaches Spain and Italy, which will not be too far behind, due to problems that are quite similar.
One should not be under the mistaken impression that Greece, Ireland or Portugal will be out of the woods once they have received their bailout packages. The funds for the bailouts will have to come from other member countries, meaning that most of them have to borrow money. Therefore each time, there is a bailout there is a greater likelihood that others countries will sink deeper into the morass from which the only to emerge will be reengage on their commitments to lenders. Each of the countries of EU facing a crisis are likely to condemned into negative or low growth for at least the next one decade. The solutions offered to battle the crisis are largely those that are unlikely to work. EU policy makers are not inclined to consider the more important solutions, including reworking on the membership of the Euro and importantly even a debt default.
One such unsuccessful attempt has been the case of Ireland, which has over the past three years attempted to cut their expenditure and shrink their economy – leading to more disastrous consequences, than fruitful consequences. Spain has been the most recent one to join the list of countries that are now keen on reducing expenditure and selling State asset, which will again have greater short-term impact rather than long-term. It is imperative to note that as they attempt to cut expenditure and shrink their economy, the revenues of the country will invariably decline thereby forcing them to miss all their estimates and projections about fiscal deficit. More importantly, in such a scenario repaying debts becomes all the more difficult as falling incomes and revenues add to the burden of debt. This will happen at a particularly inopportune time as the sovereign will be unable to take advantage of the low interest rate regime as they are considered as risky borrowers, forcing ever higher interest rate costs. All this indicates that the bailout of Greece and others will only provide a temporary respite. The case of Ireland is instructive: interest rate payments will reach nearly a quarter of its total revenues by 2014. This should be seen in the context of Moody’s claim that the average trigger for default in recent global history worldwide is about 22 percent.
Therefore the problems in Europe are unlikely to end unless there are two important structural changes. There have to be massive debt write offs or defaults (which could reach their highest in history) or more importantly simply restructure their currency, the Euro. While these are bitter pills that the EU will have to swallow in the foreseeable future, in the interregnum, they will have the manoeuvring space to take up one last measure: take up the EU version of Quantitative Easing. This short-term measure is easier said than done. There are a number of important hurdles that would have to be negotiated. First, the quantum of easing needs to consist of the right admixture that would be properly targeted, else there is a risk that banks will access the money and it would flow to other regions, thereby continuing the problems while increasing ‘hot money’ flows. Second, Germany would have to accept these, an unlikely event at the present juncture, considering the memories of the 1920s and late 1940s when a spurt in money supply nearly wiped out the savings of the Germans. The only possibility of Germany accepting quantitative would be in the case of a collapse of the larger countries in the EU. There are other problems, including the probability of a successful challenge in the German Constitutional Court questioning the bailout of Greece. A negative ruling by the German Court will invariably lead to the collapse of the German Government thereby complicating the matter and increasing the uncertainty for the EU and the global economy.
The problems that EU grapples with in the case of Greece, Ireland and Portugal are most likely to be manageable when compared to the challenges it faces with the case of Spain and Italy. The expected funds that these two countries may require range from Euro 1-2 trillion. The larger countries are bound to emerge as the focus of attention in 2011. Italy’s public debt is more than €2 trillion the largest after USA and Japan, minus their advantages.
Spain has its share of problems that are likely to rattle the world markets over the course of 2011 and 2012. IMF has estimated that the gross financing requirements for Spain will be approximately Euro225 billion or nearly 21 percent of its GDP. Italian banks need to refinance about Euros118 billion in 2011. Attracting such large amounts at low interest rates would be a challenge that would be difficult. The bond markets are already worried and the cost of financing for the country has already increased by more than one percent in the past one month. The Yield on the Spanish 10 year benchmark increased from nearly 4 percent in early November 2010 to about 5.5 percent by the end of the month. The bond markets are already pricing in nearly 25 percent chances of a Spanish default while in the case of Portugal it is 34 percent, and 39 percent for Ireland. The ECB must be clearly uncomfortable that despite all their intervention in the bond markets and their purchase of the bonds of the troubled countries, they have not been able to reduce the interest rates that these countries have to pay. Spanish public debt is modest in comparison with others, but its total debt (private and public) is more than 270 percent. This becomes an additional burden when we realise that the country has to survive with a grossly overvalued currency when it has no major competitive advantage in a fast changing global economy. The currency becomes a problem as it cannot even devalue in order to reduce the suffering and become more competitive. It cannot aspire to become a major exporter for the simple reason that the boom in Spain was due to speculation in real estate and other financial services. The supply of real estate is extremely high with a Madrid based research firm claiming that the unsold properties in Spain are about 1.5 million or about six years’ supply.
The major problem that EU countries face is that further deterioration in the finances of one country, has a cascading impact on many other European countries due to the growing inter-connected nature of global finance as it has metamorphosed in the past two decades. The chart below provides an overview of the exposure of various countries’ banking system to Spain.
Sovereign Crisis:
As time flies by, more countries seems to be ready to join their peers in the insolvent list, albeit unofficial list. Greece was the first, with now Ireland joining the list. Portugal and probably Spain will join the list in the next year or so. Despite, the growing list of insolvent nations, not many seem to be willing to experiment with fundamentally more important solutions than those that have been time-tested (most of them without success). Increasingly, the two of the most important long-term problems on the global economic horizon are the problems in Europe and a slowing China. Both these are structural issues and importantly they have to be seen in conjunction with the continuation of the debt-deleveraging cycle in the USA, which should last at least another 3-5 years.
Amid much hope, EU announced a Euro 440 billion bailout fund which would be funded by members and guaranteed by all the members. Greece is expected to use about US$145 billion, while Ireland will need about US$113 billion while a bailout for Portugal will require about US$80-100 billion. Problems as well as structural contradictions will come to the fore once the crisis reaches Spain and Italy, which will not be too far behind, due to problems that are quite similar.
One should not be under the mistaken impression that Greece, Ireland or Portugal will be out of the woods once they have received their bailout packages. The funds for the bailouts will have to come from other member countries, meaning that most of them have to borrow money. Therefore each time, there is a bailout there is a greater likelihood that others countries will sink deeper into the morass from which the only to emerge will be reengage on their commitments to lenders. Each of the countries of EU facing a crisis are likely to condemned into negative or low growth for at least the next one decade. The solutions offered to battle the crisis are largely those that are unlikely to work. EU policy makers are not inclined to consider the more important solutions, including reworking on the membership of the Euro and importantly even a debt default.
One such unsuccessful attempt has been the case of Ireland, which has over the past three years attempted to cut their expenditure and shrink their economy – leading to more disastrous consequences, than fruitful consequences. Spain has been the most recent one to join the list of countries that are now keen on reducing expenditure and selling State asset, which will again have greater short-term impact rather than long-term. It is imperative to note that as they attempt to cut expenditure and shrink their economy, the revenues of the country will invariably decline thereby forcing them to miss all their estimates and projections about fiscal deficit. More importantly, in such a scenario repaying debts becomes all the more difficult as falling incomes and revenues add to the burden of debt. This will happen at a particularly inopportune time as the sovereign will be unable to take advantage of the low interest rate regime as they are considered as risky borrowers, forcing ever higher interest rate costs. All this indicates that the bailout of Greece and others will only provide a temporary respite. The case of Ireland is instructive: interest rate payments will reach nearly a quarter of its total revenues by 2014. This should be seen in the context of Moody’s claim that the average trigger for default in recent global history worldwide is about 22 percent.
Therefore the problems in Europe are unlikely to end unless there are two important structural changes. There have to be massive debt write offs or defaults (which could reach their highest in history) or more importantly simply restructure their currency, the Euro. While these are bitter pills that the EU will have to swallow in the foreseeable future, in the interregnum, they will have the manoeuvring space to take up one last measure: take up the EU version of Quantitative Easing. This short-term measure is easier said than done. There are a number of important hurdles that would have to be negotiated. First, the quantum of easing needs to consist of the right admixture that would be properly targeted, else there is a risk that banks will access the money and it would flow to other regions, thereby continuing the problems while increasing ‘hot money’ flows. Second, Germany would have to accept these, an unlikely event at the present juncture, considering the memories of the 1920s and late 1940s when a spurt in money supply nearly wiped out the savings of the Germans. The only possibility of Germany accepting quantitative would be in the case of a collapse of the larger countries in the EU. There are other problems, including the probability of a successful challenge in the German Constitutional Court questioning the bailout of Greece. A negative ruling by the German Court will invariably lead to the collapse of the German Government thereby complicating the matter and increasing the uncertainty for the EU and the global economy.
The problems that EU grapples with in the case of Greece, Ireland and Portugal are most likely to be manageable when compared to the challenges it faces with the case of Spain and Italy. The expected funds that these two countries may require range from Euro 1-2 trillion. The larger countries are bound to emerge as the focus of attention in 2011. Italy’s public debt is more than €2 trillion the largest after USA and Japan, minus their advantages.
Spain has its share of problems that are likely to rattle the world markets over the course of 2011 and 2012. IMF has estimated that the gross financing requirements for Spain will be approximately Euro225 billion or nearly 21 percent of its GDP. Italian banks need to refinance about Euros118 billion in 2011. Attracting such large amounts at low interest rates would be a challenge that would be difficult. The bond markets are already worried and the cost of financing for the country has already increased by more than one percent in the past one month. The Yield on the Spanish 10 year benchmark increased from nearly 4 percent in early November 2010 to about 5.5 percent by the end of the month. The bond markets are already pricing in nearly 25 percent chances of a Spanish default while in the case of Portugal it is 34 percent, and 39 percent for Ireland. The ECB must be clearly uncomfortable that despite all their intervention in the bond markets and their purchase of the bonds of the troubled countries, they have not been able to reduce the interest rates that these countries have to pay. Spanish public debt is modest in comparison with others, but its total debt (private and public) is more than 270 percent. This becomes an additional burden when we realise that the country has to survive with a grossly overvalued currency when it has no major competitive advantage in a fast changing global economy. The currency becomes a problem as it cannot even devalue in order to reduce the suffering and become more competitive. It cannot aspire to become a major exporter for the simple reason that the boom in Spain was due to speculation in real estate and other financial services. The supply of real estate is extremely high with a Madrid based research firm claiming that the unsold properties in Spain are about 1.5 million or about six years’ supply.
The major problem that EU countries face is that further deterioration in the finances of one country, has a cascading impact on many other European countries due to the growing inter-connected nature of global finance as it has metamorphosed in the past two decades. The chart below provides an overview of the exposure of various countries’ banking system to Spain.
It is due to this interconnected nature of global finance that no country seems to be willing to advocate a complete overhaul to solve the crisis. They prefer small incremental changes rather than drastic overhaul, lest it destabilise their own countries. Germany is a classic case: they would like to portray the impression of being against bailouts but are forced to accept a bailout at the last minute for the simple reason being that refusal would lead to a collapse of their own banks. Add to the problems of Spain, the problems of Italy and we have a picture of a possible disaster in the European Economy.
Real Economy may be getting worse:
Contrary to general perceptions, on a closer scrutiny, the real economies (contrary to the financial markets) are at best growing only marginally, if at all. On a number of metrics, they seem to be getting worse. Add to this the unfavourable demographics and we will find that EU continues to be in trouble. An added additional burden is the fact that decision making is possible in the EU only through consensus due to the number of countries that make up the EU. Consensus is always accompanied by compromises, a system that may not work very well, especially in the face of such a major crisis. The UK is about to witness large scale cut back in the public sector. It has been pointed out that in UK, almost four million people are behind with their bills and are being forced to resort to their credit card to make up the shortfall.
Almost all the countries of Europe are in the midst of draconian cuts in public expenditure and downsizing. It is safe to assume that the devastating consequences of this will be felt in full force only from the third quarter of the calendar year 2011. The most recent example is Spain which has decided to cut an extraordinary jobless payment of about Euros 420 in the face of unemployment that stands at 20.7 percent. It is probably due this that most of the companies are willing to increase their investments, though many of them have sufficient cash resources, as they have been holding since the collapse of Lehman Brothers. It has been estimated that the US companies hold nearly US$1 trillion of cash on their books, while the top 500 companies of Euro region hold nearly US$700 billion.However, net of debt, this would be probably only a tenth of the amount reported.
The marginal improvement in the world economy may be more related to the cyclic recovery and as a consequence of the efforts of the various governments to stimulate the economy. That phase ended almost six months ago and the economies are on the verge of suffering a relapse. The growth in exports may largely be a product of inventory correction and demand held back due to cut backs in the aftermath of the crisis as well as currency weakness. The rise in the Euro in the aftermath of the fears about US Quantitative will have a negative consequence that will be more clearly discernible over the next one month. Any weakening of the Euro may be a blessing in disguise for the stricken economies of Europe. owever, it would be imprudent to rule out the rule out another recession, unless the ECB decides that they would have to introduce their own version of the Quantitative Easing. USA has already realised this and it is probably for this reason that Bernanke has already indicated that it will expand its quantitative easing beyond the already announced programme. Europe’s problems are compounded by the fact that it is the largest trading partner of the USA, which is in the midst of multi-year debt de-leveraging cycle. ECB will want to buy more time in the hope that the political leaders can come to an consensus that has alluded them till date, and that would mean more Quantitative easing. This is probably what the precious metals have smelt.
You refer to a "weakening of the Euro". I envision a sudden and sharp loss of value in Euro.
ReplyDeleteEurope's debt woes are not a top concern for most investors but should be as Cliff Risk emerged in the European Financials, EUFN, on November 5, 2010 as sovereign and corporate interest rates rose and as currency traders sold the Euro and other currencies. It was on this date that the world pivoted from the age of prosperity and into the age of deleveraging, as is seen in the MSN Finance six month chart of world government bonds, BWX, the 30 Year US Government bonds EDV, and the 10 to 20 Year US Government Bonds, TLT.
This week, European Financial Institutions, EUFN, were restored to life by ECB announcement of ongoing purchases of debt. World government bonds, BWX, and international corporate bonds, PICB, rose, which contrasts with US Treasures, EDV, and TLT, as well as US based corporate bonds, LQD and BLV, which fell lower.
The European Financial Institutions, EUFN, in particular these eight: Deutsche Bank DB of Germany ….. Banco Santander, STD, Spain ….. ING Groep NV, ING, Netherlands .…. Credit Suisse, CS, Switzerland, ….. Royal Bank of Scotland, RBS, Scotland ….. HSBC, HBC, United Kingdom ….. Barclays, BCS, The UK …... UBS, Switzerland ….. have gone beyond the tipping point and are at cliff risk ….. as the liabilities of the bank-sovereign debt symbiosis grow stronger.
Soon the European Financial Institutions will be going over the cliff, as the sovereign crisis deepens and bond vigilantes call interest rates higher, the market insiders short sell the banks, and as currency traders sell the Euro, FXE.
Out of Götterdämmerung, that is a investment flameout, a Sovereign, that is a European Chancellor, a leader like Herman van Rompuy, and a Seignior, a top dog banker, like Olli Rehn or Jean Claude Trichet, will emerge from Europe’s Core, to provide fiscal sovereignty and both credit and fiscal seigniorage through a common EU Treasury and implement strong economic governance like the world has never known or even thought possible.
The investment application is to purchase and take physical possession of gold and silver bullion.