EU Deal: Show Me the Money!

The announcement by Euro Zone leaders was greeted by euphoria in the markets, almost all the markets. The only group of investors who seem to be a bit sceptical are incidentally, the smartest investors in the Bond Markets. Going by the yields of Italy and Spain, which were down only marginally, their attitude seems to be very simple: Show me the money first! This attitude seems to be justified considering that the recent move may at best buy some time before the problems come back to haunt policy makers, albeit with greater force in the very near future. At best the measure will provide a breathing space for about 12-18 months and, at its relief for 4-6 months.

The EU policy makers seem to have been in a hurry to announce policy measures with little detail, probably due to the nature of European politics and as a move to force compliance within their own disparate group to the broad contours of an agreement. The leaders, especially the obstinate Germans, need to be commended for their ability to strike a deal in order to avoid immediate suicide. In this context it is important to briefly review the nature of the problem and if it is sufficient to place EU on the road to a sustainable recovery.

In brief, the deal plans to leverage the present European Financial Stability Facility (EFSF) so that it can be used as a vehicle for bailing out nations, a ‘voluntary’ rescheduling of Greek debts where the investors agree to forego 50%, recapitalisation of the banks and the need for the banks to raise their Tier I capital to 9% by June 2012. A significant feature of the deal was the announcement was that the EFSF would, with leverage, total about US$1.4 trillion. The fund would partly insure bonds and, as a last resort even bailout banks.

Apart from questions such as, is size of the EFSF sufficient to meet the problem, the deal raises more questions than it answers.  First, nobody (hopefully excluding the EU policymakers) have any inkling as to where the money will come from. Officials hope to raise money from investors and borrow money. The only problem is that in the era of deleveraging cash is a scarce commodity. It is well known that the banking system of Europe (and most probably even USA) is more or less insolvent and it would be difficult to believe that they can come up with the cash to finance what may be the complex task in the world. Considering that the stated German anathema to printing money (which may actually be only medium term solution) it may be a classic case of too little, too late.

Second, it is difficult to believe that rescheduling of Greek debt will be the last. This is risk is especially pertinent as slowing economies of Portugal, Spain and Italy will require substantial help in the next 1-2 years. Hence, in that context any investor, who if s(he) is managing their own money would find it difficult to invest money in such a fund. The deal is unlikely to inspire

Third, at a very fundamental level, the deal does nothing to solve the underlying problems that got the world into the crisis in the first place: too much debt and a faulty economic model based on building on the global economic imbalances. It does little to solve Southern European countries loss of competitiveness in the global market place (estimated as high as 40%). The policy makers seem to have forgotten an old adage: One can never borrow ones way to prosperity. Banks made the mistake of borrowing money through financial engineering. A bank can be bailout by a Central bank. But what or who will bail out the Central banks?
A simple answer: Wholesale Default on debt. Probably that will be only solution to the present crisis.

Overview of Recent Macro-economic Trends

Interesting Macro-Economic changes discernible from the last 20 days of market action:
1. Bond Yields of Italy exceed that of Spain. Indicative of a trend? Yes, I think so. The rising yields should be seen in the context of the large scale rollover/repayment of debt (variously estimated at US$2-4 trillion) in the next one year.
2. The Interesting similarity of with 2008 is that policy makers are putting forth essentially the same arguments about the health of the system as the US policy makers put forth just before Lehman - that goes for a lot of others including the CEOs of banks. Remember Lehman CEO himself claimed three days before the firm collapsed that they had sufficient capital. The problem with modern finance is that hoards of cash can move out with the click of a mouse. At least in the 1920s bank runs were more easily visible. People had to line up in front of a bank to withdraw their money and carry it out in bags.
2. Lots of talk about a bailout for the banks, through recapitalisation. this is likely in the G-20 Meeting at the end of this month or November 2-3. But the problem with bailouts, is that the proposed bailout fund largely consists of fiscally stressed countries guaranteeing the debt of other nations. The logic of wisdom that thinks such a programme can succeed is similar to the claims that we had about 2 years ago that if countries take up austerity programmes this would go a long way in solving the Eurozone problem in the next 2-3. Greece should give us the results.
3. Quantitative Easing of various hues seems to have started and is likely to become more pronounced in the next 2-3 months. This should create a mirage of recovery but the law of diminishing returns of more money pumping seems to have kicked in. This will have at best marginal impact.
4. The most interesting long-term development is that default is more taboo. One year back, the mention of the 'D' word (default not depression or deflation) caused much consternation amongst European policy makers. That now seems to be missing. This should considered great progress. My personal view is that if there has to be a lasting recovery, then at some point there have to be a massive defaults and write off of debts. Such a write off would not only reduce the total debt but would also reduce the speculative element in the global economy. Take for instance the total global GDP (which is less than US$60 trillion) while the notional value of derivatives is nearly US$605 trillion (most recent BIS estimate). Such levels of speculation led us to the crisis. I would speculate that the global economy will not witness any vibrant growth as the deleveraging from debt has a long way and this would be followed by a major fall in the asset prices (and with it the notional value of outstanding in the derivatives) over the next 5-7 years. That would indicate that the world's financial markets are likely to mimic the movement of Japanese markets over the past two decades: Sharp rallies while the overall trend will be largely down. Falling asset is likely to mean that deflation is likely to be the predominant focus of attention over the next 2-3 years, if not beyond that.
5. A detailed analysis of the price movements of various agricultural commodities seems to indicate that these commodities (especially rice, cotton and sugar) are likely to be the focus of speculative activity. Deflation or not people have to eat and with rising populations and problems that originate from the vagaries of nature are likely to be the major causes. The next round of stimulus will make commodities the first beneficiaries of easy money for the simple reason that almost all the agricultural commodities lack the depth to absorb large amounts of capital.