Thoughts On The Euro Zone From An EM Perspective

from BBH colleague Win Thin

We’re not sure why there is even any debate in the market about private sector burden sharing with regards to peripheral debt. Of course there will be haircuts involved. Looking at the current euro zone problems through an EM lens, we firmly believe that debt restructuring with significant haircuts is the only long-term solution. Otherwise, it’s a bunch of band-aid solutions that feed into a “Lost Decade” of slow growth, recession, and high unemployment. That’s what happened in Latin America. We would also stress once again that it wasn’t just the debt restructuring that saved Latin America, but also the sweeping economic reform programs that were supported by the IMF and World Bank that helped Latin America turn the corner. Indeed, we would say that Brazil and Mexico’s current success came about from the Brady Plan of 1989. If peripheral euro zone is to escape the current turmoil with a better outlook, we think both components of the Latin American example will need to be implemented.

We find it disingenuous for the EU to push for burden sharing (haircuts) that is limited to new debt issuance, but not grandfathered to include the existing stock of debt. Currently, that is the EU’s stance but we cannot fathom how any debt restructuring can avoid restructuring the existing debt stock. After all, servicing the existing debt stock is the root cause of the problem. If debt/GDP ratios are to be brought down to more manageable levels from the stratospheric heights currently, then there is no choice but to institute an all-inclusive debt restructuring that leads to significant haircuts for ALL bondholders of the peripheral issuers.

For now, talk of a rescue plan for Ireland continues to make the rounds. However, we note that Ireland is fully-funded until mid-2011. Ireland’s debt agency said that its gross funding needs will likely be EUR23.5 bln for 2011, EUR20.7 bln in 2012, EUR18.9 bln in 2013, and EUR18.6 bln in 2014. That’s a total of EUR81.7 bln, which lines up quite nicely with the rumored EUR80 bln rescue package. To us, the big risk is that Ireland has done the right stuff but has more often than not underestimated the ultimate costs of their plans. That’s why we can’t put much stock in these latest numbers. What if interest rates stay elevated? With debt/GDP around 100%, each percentage point of higher borrowing costs can significantly hurt the debt dynamics. Continued upward adjustments in the banking sector bailout costs by Ireland have hurt investor confidence in the country as badly as fudging economic data has hurt Greece. Either way, investors are left with doubts as to whether the numbers can be trusted.

One last thought: the Greek rescue plan/EFSF/European bank stress tests were all designed to instill investor confidence in the periphery and to lower their borrowing costs. That hasn’t happened, so why would an Ireland rescue be any different? There could be a short-term bounce in the markets from the announcement effect, but when the dust settles, we think the same issues will come back to haunt peripheral euro zone until a Brady-style plan is instituted. For instance, the euro bounce from the rumored rescue plan has run out of steam below 1.38, and we think investors will continue to sell into euro rallies for now as the underlying fundamentals in the peripheral euro zone remain shaky at best. EM currencies also recovered on the bailout rumors and reversed earlier losses, but we continue to believe that risk off trading will prevail into year-end and keep EM FX trading softer.