The world’s attention is on the fiscal malaise in Greece and Portugal. Just a few months ago, policy makers told banks to shore up their balance sheets with more sovereign debt. However, policy makers around the world have since raced to spend money in an attempt to reinvigorate their respective economies, leading to record deficits. Now everyone appears surprised that weaker countries are having difficulty financing their largesse.
In our assessment, what we see unfolding is a sign of greater instability to come. That said, writing off the euro may be premature; as global dynamics play out, we believe the euro may yet prove to be an anchor of stability.
Making of a Panic
Portugal sold €300 million euros (approx. US$411 million) of 12-month bills on February 4, 2010 after indicating it planned to issue €500 million euros. The securities sold at a yield of 1.38 percent, compared with 0.93 percent at a January 20, 2010 auction. Without trying to play down the significance of not being able to attract the expected number of bidders: 1.38 percent in interest is not expensive, especially not for a country that is said to have major challenges in bringing its house in order.
Could it be that the problem is that rates are too low? In our mutual fund business, we have never purchased Southern European debt securities because the yields available, in our humble opinion, are simply not commensurate with the risks one is taking. The recent dearth in demand suggests other investors finally agree.
Part of the reason why the Portuguese auction was ill-received may have been because those who participated in a €8 billion 5-year bond offering in Greece a week earlier were punished within less than 24 hours, as those bonds plunged, pushing yields higher. The Greek government had not taken any chances, enlisting top banks to place its debt, and there had been enough bidders to place €25 billion. Investors willing to buy Greek debt likely have a significant overlap with those willing to finance the Portuguese government; with these investors burned, it is not hard to see why a “routine” auction in Portugal could easily go sour.
This April, Greece has €12 billion in debt maturing with another €8.4 billion in May. Portugal has €3.9 billion in bills maturing in March with another €7.3 billion in May. In contrast, the U.S. issue calendar for the week of February 9 lists US$ 158 billion in bills, notes and bonds, not including (as of this writing an unspecified amount) 4 week bills to be auctioned. Having said that, the U.S. economy is roughly 40 times larger than that of Greece and 60 times larger than that of Portugal. Long story short: there is a lot of money to be financed over the coming weeks and months (the supply side) and someone needs to buy it all (the demand side).
To make it more challenging for Greece, the European Central Bank (ECB) may not accept Greek debt securities as collateral any longer after the end of the year. Traditionally, banks may use investment grade rated debt securities rated A- or higher to get temporary cash from the ECB; as a result of the crisis, the ECB is, until the end of the year, accepting securities rated BBB or above. The major rating agencies currently rate Greece’s debt as BBB+ (S&P), A2 (Moody’s) and BBB+ (Fitch). ECB President Trichet has been urging banks to take advantage of favorable market conditions to bolster the balance sheets by raising capital; large holders of Greek government debt, Greek banks in particular, should take note, as their liquidity will be affected should the ECB refuse to take Greek government bonds as collateral to get cash to run operations.
Note that Portugal’s ratings are higher (AA2 by Moody’s; A+ by S&P; AA by Fitch) and currently not at risk from being excluded from ECB refinance operations. However, on Friday, February, 5, 2010, Portugal’s minority government, the ruling Socialist party, was defeated in trying to rein in spending: the opposition-dominated parliament passed a bill to subsidize two regions of Portugal by €50 million this year, with increasing amounts for each of the coming years. Just like anywhere else in the world, it seems that politicians find spending cuts unpalatable.
ECB President Trichet has gone out of his way to play down the threats stemming from weaker countries; he doesn’t downplay the countries’ problems, but their relevance for the eurozone and the European Union. Greece contributes about 2% to the eurozone’s Gross Domestic Product (GPD); compare that with California, which contributes over 12% to the GDP of the U.S. (see our commentary Greece No California). But that’s only part of the story. Take German banks. German banks are huge, but Germany’s fixed income markets are under-developed relative to the size of the economy; that’s one of the reasons German banks have exposure to just about any crisis that flares up in the world. However, the point is not really whether German banks have robust enough balance sheets; the point is that panic can spread if there is the perception that banks are not sufficiently robust.
Euro as Anchor of Stability
Credit Default Swaps (CDS) on Greece and Portugal spiked on Thursday, February 4, the day the Dow plunged by 268 points and the euro fell versus the U.S. dollar. However, if this were a sign that the euro is to implode, why did the euro rise relative to gold? Let’s look at some of the issues at hand:
Fiscal dicipline
To balance a budget, revenues need to be increased or expenses cut. Revenues may be increased through higher growth or higher taxes. In a country like Greece, many doctors declare incomes of only €30,000, far below their actual income. The government wants to crack down on tax evaders; such crackdowns are nothing new, yet they are generally ineffective. If people don’t trust their government – amongst others, Greek bureaucracy is rather corrupt – they will look for ways to hide income (see our commentary in the Financial Times).
But before we commit the foolish mistake of simply assuming the U.S. regulatory system is so much better, raising taxes in the U.S. won’t easily fix our fiscal problems, either. Taxing the rich at 100% won’t balance the budget. Also note that it’s not only Greek citizens who can get creative when hit with tax bills they deem unfair. That creativity need not be illegal: the wealthy in particular will find ways to postpone incurred income when faced with higher tax rates.
The main challenge in developed countries is that populations are ageing, putting severe strain on welfare benefits. Incidentally, Spain is proposing to raise the retirement age from 65 to 67; those types of reforms are urgently necessary, but rather difficult to implement.
The most prudent way to get deficits under control is to cut spending. However, that’s easier said than done. Greece is likely to have a national strike in the coming days, followed by a strike by tax collectors. And again, we don’t need to look to Greece: the “pay-go” rule just passed by the House in the U.S. is a far cry from the pay-as-you-go rule in force last decade: the rule stipulates that increased spending somewhere must be offset by cuts somewhere else. The new rules make for nice headlines, but if Swiss cheese were to be made according to the new rules, there would be no cheese for all the holes!
California, with its dysfunctional budgeting process, shows just how difficult it is to raise revenue or cut spending. However, Greece can also learn a thing or two about survival without defaulting on its obligations: issue revenue bonds tied to sales tax rather than general obligation bonds (such bonds reduced the borrowing costs for California); or pay those you can with IOUs. We are not suggesting Greece should use those to fix its budget problems; but there are tools available to manage short-term liquidity crises without causing a run on the system.
From a fiscal side, an inability to access the debt markets has its advantages: you are forced to stop spending. In California, we may not like the furlough days for government employees or other cutbacks, but they do work in reining in expenses. However, social unrest is a real concern in a place like Greece. As a result, we would not be surprised if Germany in particular, though likely in concert with other European nations, ultimately subsidizes Greece: not because of budget concerns, but for the sake of peace.
Having said that, in order to encourage a country like Greece or Portugal to introduce reforms, playing tough may be required even if a rescue package may ultimately come. With a national strike looming in Greece, the government would have little chance to stand its ground if help was lined up.
Euro
In the U.S., we may not like the politics of the day, but for better or worse, we generally know who is in charge. The Chairman of the Fed in conjunction with the Treasury Secretary, have shown the willingness and ability to act during the financial crisis. While Europe has a central bank, there is no European Treasury Secretary with the ability to stuff billions into any one bank or member state. In Europe, when a bank was at the brink of failure, the respective national, at times regional, governments had to act. Similarly, Europe is structurally incapable of creating a euro-zone wide stimulus package as efficiently as the U.S.
The implications of the different structures cannot be stressed enough: in the U.S., we can spend billions, even trillions, comparatively easily. In Europe, the rigidities make spending far more difficult. And member countries of the euro zone cannot print their own money, but have to tap into the debt markets.
In our assessment, over the medium term, this may cause the euro be significantly stronger than the U.S. dollar because less money will be spent and printed in the euro zone than the U.S.
At its February 4 press conference, ECB President Trichet was asked whether countries that rein in their deficits would see lower growth as a result. He responded that countries that take deficit reduction seriously should gain investors’ confidence and, as a result, see increased investments. In our assessment, Trichet is absolutely right and we wish other policy makers would listen to this train of thought. Over the short-term, tighter budgets may mean less growth. However, because the euro zone does not have a significant current account deficit, weaker economic growth does not necessarily lead to a weaker currency. In our assessment, countries with current account deficits, such as the U.S. or Australia, need to show economic growth to attract investors to support their currencies. Note that Ireland – frequently mentioned these days in conjunction with Portugal, Greece and Spain as part of the “PIGS” countries – has swallowed its tough medicine. Ireland’s austerity package, in our assessment, will help to regain investor confidence.
Ultimately, who has failed since the onset of the financial crisis? Aside from investment banks Bear Stearns and Lehman, few significant players have. Insurance giant AIG was rescued; government-sponsored entities Fannie and Feddie were put into conservatorship; Dubai has been given a lifeline. And how are these rescues achieved? Generally speaking, by printing money.
Because the euro zone is more restricted with regards to how it spends money (the requirement of any euro zone member to show how to bring deficits to below 3% of its respective GDP to adhere to the “stability and growth pact” is a key contributor here), reforms in the euro zone will have to come sooner than in other places. On the monetary side as well, ECB policies have been far more robust: unlike the Fed, the ECB never piled up mortgage backed securities onto its balance sheet that may create significant problems conducting monetary policy over the coming years. In our assessment, despite the pain, the euro zone will be better off as a result.
The best encouragement to induce reform is to be punished by the markets for bad behavior. As such, we welcome the increased spreads within the euro zone, i.e. the fact that Greece now has to pay almost 4% more to issue 10-year notes than Germany. A failed auction is also a wakeup call. The big question is how national politics react when faced with reality.
If a country were to be kicked out of the euro zone, it would send a very strong signal to the others to get their house in order. Unfortunately, there have been thousands of pages written of how to join the euro, but we haven’t seen the sections on how to exit the common currency. For any member country, despite all the pain, it’s still cheaper to be part of, rather than out of, the euro zone. Having a member states’ debt banned as collateral from ECB refinance operations is about as close to being kicked out as is likely to happen.
In practice, what we expect over the medium term is that the rest of the European Union will provide assistance to the weaker members, similar to when the IMF helps a country. There are already European supra-national institutions that could be used to channel such help, such as the European Investment Bank.
It’s always popular to bash Europe; and by all means, there are plenty of problems in Europe. However, we believe the weakness in Europe may be a buying opportunity. Remember when the European constitution was rejected and pundits called for the end of the euro zone? The way Europe conducts business is certainly different from what we are used to. But while the U.S. may try to inflate itself out of its problems, the euro may very well prove to be the anchor of stability in an increasingly unstable currency environment.
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