27 January 2011

Europe and the euro zone at the forefront again

In Europe, the beginning of the year started at full speed from day one.
First, the EU earmarked Estonia joining the euro zone as a proof of the continuing success and attractiveness of the euro as if this event would fool any sensible investor.
At the same time tensions reappeared with spread widening again for PIGS countries debt ahead of Portugal and Spain financings. These debt auctions however went rather well which eliminated the immediate need for action and spreads contracted whilst still at unsustainable levels for the long term.
Finally, the Eurogroup and ECOFIN met in Brussels on the 17th and 18th of January to prepare the head of states meeting due to take place on the 4th of February. The main purpose of these meetings was to discuss potential changes to the European Financial Stability Fund (EFSF) to create a permanent rescue mechanism where 4 options will probably be discussed:
1. Do nothing (suicidal)
2. Increase the size of the EFSF (the preferred solution for many but the Germans so far)
3. Reduce the interest charged on EFSF loans (cosmetic)
4. Increase the scope of sovereign debt purchases (complements point 2)
Whatever, with its endless printing press, the ECB could expand the scope of its purchase of government debt in the secondary market, even if the Germans would hate it. So I do not expect the collapse of the euro zone but for the German blowing the whistle - most unlikely - (I am awaiting the decision by the German High Court of Karlsruhe about the constitutionality of the EFSF): politicians are making the taxpayer pays the highest price to save the euro.
There are many reasons why designing a better system for managing the euro zone is proving very difficult. Virtuous countries rightly want the pain to be felt by profligate ones which in turn try to limit/postpone tough austerity measures, any politician having permanently his eyes on the next poll and being always reluctant to decisively act with unpopular measures, even when necessary. The fundamental problems of the euro zone remain unresolved:
1. Over-indebtedness of sovereign states
2. Toxic assets in banks’ balance sheets
3. Over-leveraged banks
4. Much slower growth in the euro zone than the rest of the world
5. Competitiveness gap between Northern Europe and Southern Europe
I continue to believe that (1) adding debt to an over-indebtedness problem will only postpone the final cure and make it sourer and (2) an early and orderly restructuring of the liabilities of de facto defaulting countries will begin to solve this mess.
This would imply bondholders taking a haircut which might lead to some banks being bankrupt – sensible when the wrong management decisions were taken (ok, the question of imposing haircuts on bondholders has to be addressed); alongside a mechanism should be implemented to ensure that savings will be safeguarded for both individuals and corporations. And I do not take on board the bullshit that banks spread about the need to save them so they can lend to the economy: so why do they have so much sovereign debt on their balance sheet? Because it was an easy way to play the yield curve to replenish their shareholders’ funds investing in sovereign “risk free” debt and continue business as usual despite the rhetoric (a bit a remake of the subprime, but made in Europe this time: no analysis of risk, invest in riskier –but not so risky…- assets for a small yield pickup, instead of doing a proper job). So far, the taxpayer is the only one on the hook: this is neither a balanced solution nor an efficient one. My guess is that the burden of the crisis will be more evenly shared.
This would also result in some pension funds and other bond and money market investment vehicles incurring losses, and so what? Did anybody guaranty pension funds, equity investment funds or individuals for their 2008 stock market losses? No, investors act by either re-allocating assets with other managers or classes, or by waiting (hoping) for a recovery.
As Martin Spring’s writes in his January’s newsletter: “As long as Europe’s toxic debt problem remains unresolved, we can expect further currency crises as speculators seek to profit from politicians’ cowardice like Vikings raiding poorly-defended shores.”

The New York Time: Support Grows for Larger European Rescue Fund