14 February 2010

Sovereign risk is back with a vengeance

Concerning Greek’s crisis, Thursday’s declaration of European Union leaders at a summit in Brussels stated that Countries belonging to the euro "will take determined and coordinated action, if needed, to safeguard financial stability in the euro area as a whole”. Once more, words, hot air, waffle but nothing concrete. Sarkozy says that Europe will not let one of his members default? Where is the checkbook? Markets need facts, not words.

1. The premises of the construction of the European Union and the Euro were flawed
This just shows how flawed the European Union construction and the Euro are under the past and current rules. After joining the Euro with over-valued currencies, Club Med countries (you can add France and probably Belgium to it) carried on profligate policies and did no make any serious progress towards in-depth reforms to reduce/eliminate budget deficits and lower the debt/GDP ratio. Policies have been short sighted, but reality bites. And the Treaty of Lisbon is another fraud: what was meant to designate a strong President of Europe and a unified foreign policy in total transparency ended up with a puppet President and an incompetent Foreign Minister both nominated behind close doors after petty bargaining.

Politics guided the EU construction and not sound and down to earth precepts. The one fits all does not works. The real problem is the huge differences in competitiveness between the eurozone's richest and poorest members. Having more members for the sake of showing to the public (voters?) momentum in the EU construction and believing that countries would do whatever is necessary to fit in is non-sense. The Greek central bank trafficked data to abide by the Maastricht criteria and join the Euro; this was known and no sanction has been taken for the past 11 years. In 2004, along with Germany, France succeeded in forcing the EU to relax its strict eurozone rules (maximum 3% budget deficit/GDP and 60% debt/GDP), allowing both member states to continue overspending. For example, since 2002 France had 5 years (including 2009) above the limit for budget deficits and since 2003, every single year its debt/GDP has been above the limit.

The global financial crisis is either pushing reluctant European governments (and understandably) toward deeper economic and political integration with a loss of sovereignty or leading to a different form of European governance, where countries not abiding by the Maastricht treaty convergence criteria would get real sanctions or get out. My choice is for the latter.

2. What’s on for Greece?
There is no good choice for Greece: after decades of free ride, Greeks will have to pay the bill that stands at EUR 254 billion. However you turn it, Greece is in for several years (a decade?) of recession, or even depression. I read in several papers that Greeks are moving their money away from Greek banks and send it abroad. Time is really running short and politicians will not be able to blame anybody else but themselves for this sad story (but the usual speculators – easy and populist).

European countries are in no fiscal position to bail out Greece (and then Portugal, Spain, etc.), and should not in any case. In addition, EU treaty clauses restrict bailouts of euro member countries. Why the German taxpayer should pay for the lack of efforts of Greeks?

I understand why Sarkozy says that Europe will not let Greece default: according to the BIS (Bank for International Settlement) French Banks are in the first line for the amount of Greek debt owned. According to John Mauldin’s letter, reporting information received from Moody’s Lisa Hintz (emphasis mine):
"The numbers as of last June were France €86 billion, Switzerland €60bn, and Germany €44 billion. I have seen more recent numbers of France €73b, Switzerland €59b, and Germany €39b. In terms of GDP, for Germany it is minimal - just over 1%. Of more concern, for France it is nearly 3%, and for Belgium 2.5%. For Germany, the debts of Ireland, Portugal and Spain are much bigger problems. They may, however, worry that if there is a contagion, they will have to take marks on that debt. That would be a real problem - nearly 15x the size of the Greek issue."
Despite probable hedging and taking into account that a defaulting Greece would not result in the debt being worth nothing, it could however trigger a new credit crisis since all countries with high debt and high deficit with no severe measures taken to reduce them would see CDS spreads widen and Government bond yields turn much higher. Many countries would see their ratings cut (but for pressure on rating agencies). However either the ECB would jumped in and provide ample liquidity and/or the mark-to-market will be replaced by a “managed” mark-to-market.

Let’s the IMF do the job in Greece; after all, Hungary and Latvia had the IFM coming to the rescue, why not Greece?

I do not see how Greece can reduce its deficit below 3% of GDP by 2012 with the longstanding distrust of Greeks in their successive Governments and public sector employees already striking before reforms start to bite (by the way who knows whether their real deficit is 13% and not 15% like Stratfor estimates or more - Greece apparently hid about 40 billion euros of debt from the public and EU governing bodies? Why should we believe their official numbers now when they have cheated for 11 years?). Greece has been in default for 105 years out of the last 200. They have never had a balanced budget, at least not willingly.

And why should Greece get a special treatment when Ireland is making very strong and difficult efforts to put its house in order without asking anything to anybody? Greece could not borrow in the international debt markets even at prohibitive rates; they would be forced to control their budget by the IMF (or the EU?) and would probably get into a depression. This is the price to pay and it would serve as a warning example to all other countries that have lax fiscal policies in Europe. This would be very positive long term for the EU. Otherwise, Germany and some others countries controlling their budgets and taking the tough route of deep reforms will get fed up and could try a new experiment: a two tier Europe centered on Germany where new countries would be allowed to join after having demonstrated for a number of years a responsible behavior. The interesting point would be France that sits in the middle. Whatever the solution found for Greece, it cannot be in isolation: Portugal, Spain and Italy have also to be taken into account, and possibly France and Belgium.
Whilst it would no be the end of the world, it would be a remake of the financial turmoil of 2008/2009 with different actors: the sub prime and banks would be replaced by Sovereign states. The collapse of the EUR 250 billion (300? 350?) of Greek debt would rapidly reach Portugal, Spain and others with EUR 2 trillion of debt downgraded. We would either risk a severe depression or more quantitative easing leading to inflation later on. Anyway ugly, and better to swiftly deal with the Greek problem and rapidly find solutions for Portugal and Spain.
At this juncture of the current crisis, we have move to the real possibility of debt defaults of a sovereign nation in the Western world (Japan included and in the first line of fire). Like any corporation or any household, a country cannot live for ever on recurring budget deficits and increasing debt.

Last thing, this is happening when Europe went to a standstill GDP growth in Q4 and China is tightening bank’s lending belt. Axel Weber, President of Germany's Bundesbank, warned this week there is a chance his nation's economy will contract in the first quarter of 2010, in a major blow to recovery hopes. One brighter spot, the economy seems to be getting traction in the US as showed by the data released for January; however with the economy still shedding jobs (albeit at a lower rate), the housing market still wobbly and household debt shrinking, consumer spending is likely to remain subdued.

Bond vigilantes are out and are not going to wait forever: the few coming week are going to be the day of reckoning for many countries with unsustainable deficits and mounting debt. Greece needs EUR 20 billion in April to refinance maturing debt. The day of reckoning is going to be particularly painful for policy makers who have used scapegoats to avoid taking unpopular but necessary reforms: they are in the frontline now and cannot hide. Unfortunately, the population will also suffer and dearly.

Remain short financials and the EUR. Be long precious metals and companies with low/nil debt, strong franchise and able to pay a 3%+ dividend yield (pharma, energy, water, staples), and technology (selectively).


WSJ: Europe Vows to Save Greece

WSJ: Greece Leans Toward Long-Term Loan

NYT: Europe Commits to Action on Greek Debt http://www.nytimes.com/2010/02/12/business/global/12union.html?ref=world

The Economist: New dangers for the world economy

Telegraph: Will markets call EU bluff on Greek rescue?

FT: European governments look to tap US investors

Daily Mail: Collapse of the euro is 'inevitable': Bailing out the Greek economy futile, says FRENCH banking chief

Thoughts from the Frontline: Between Dire and Disastrous