Europe – Lacking Proper Diagnosis, Cure Remains Elusive

By Marc Chandler and the BBH Currency Strategy Team

Europe’s debt crisis remains among the most important factors in the global capital markets. By some market-based measures, like interest rate spreads and credit default swap prices, the crisis is more acute now than it was before an assistance package was belatedly cobbled together for Greece. Indeed, the establishment of the temporary European Financial Stability Facility (EFSF) more than half a year ago the, the ECB’s covered and sovereign bond purchases, and the coordinated assistance package for Ireland have done little to quell the market’s fears.

The premium, for example, that Greece is forced to pay over Germany reached a new record in the first week of 2011 — but it is Portugal that is in the cross-hairs. Portuguese 10-year yields rose nearly 60 bp to new euro era highs in the first few days of the New Year, while some of its banks’ shares fell to 17-year lows. This came despite the Prime Minister Socrates assurances that Portugal reached its target to reduce the budget deficit last year to 7.9% of GDP from 9.3% in 2009.

Portugal in the Cross Hairs

Portugal’s bonds have been sold off and there was a clear impact on short-term euro money market conditions when the country announced that it would sell bonds on January 10. There is a financial Heisenberg uncertainty principle at work here, or what George Soros has called “reflexivity”. The more market participants fear that Portugal will have difficulty refunding itself – namely, by paying higher interest rates to fund this year’s deficit, the more investors fear it will become the third euro zone sovereign to require assistance and thus the more likely it will happen. A self-fulfilling prophesy indeed.

Portugal did raise money in the bill market last week, but at the cost of sharply higher yields. The 6-month bill yield rose to 3.68% from 2.04% in September and a little less than 60 bp at the start of 2010. It is not being “locked out” of the capital markets per se, but the rates it is being forced to pay are increasingly punitive. Likewise, Portugal’s 10-year bond yield finished the last week of 2010 just above 7.05%. While this may appear to build in a concession that may bring in some buyers at this week’s sale, the risk is that investors will demand even greater yields in weeks ahead.

Even if it got what seems to be an unattractive rate charged, Portugal’s assistance from the EU and EFSF (and IMF) could be secured for around 200bp less than currently demanded by the market. Of course, the higher the market drives yields in the period ahead, the greater the incentive to seek an assistance package. Moreover, given the fiscal consolidative measures already implemented, including a hike in the VAT, the conditionality may not be much more onerous than current policy.

The 7.0-7.5% area appears to be an important pain threshold. Additional austerity measures may be required in order to offset the higher debt servicing costs. At the same time, higher interest rates and fiscal austerity will undermine what minimal growth prospects Portugal may have, which in turn leads to greater counter-cyclical spending and lower tax revenues. Arguably, without assistance, Portugal likely succumbs to a vicious cycle. As such, Portugal is likely to seek assistance in the coming weeks, before the end of the first quarter.

Misdiagnosis Leads to Malpractice

The first decade of monetary union appeared to go well — though it will be recalled that, contrary to most expectations, after its launch the euro depreciated by nearly 30%. Equally important, in the end it took coordinated intervention by the major industrialized countries to arrest the euro’s slide. The initial fiscal excesses were not on the periphery, but in fact in Germany and France. Nods, winks and political maneuvering prevented them from being fined.

The financial crisis revealed the depth of Europe’s sickness. The challenges inherent in monetary union in Europe without fiscal union festered below the surface for years. There seemed to be greater convergence in the run-up to monetary union since then. The lack of competitiveness in countries like Greece and Portugal were concealed by those same forces that fueled the real estate excesses in Ireland and Spain: Low interest rates, easy credit, and a regulatory system that was antiquated, and in any event easily gamed.

Yet European officials have misdiagnosed its ailment. The official line and one that many investors seem to have accepted at face-value runs something like this: Monetary union gave the peripheral countries access to German-like interest rates, credibility and currency, but not the German fiscal discipline and conservatism. The lack of sufficient iron in the blood and starch in the spine of governments in the periphery is the main cause of the diseases that now threatens EMU’s existence.

While this seems intuitively true, it is factually wrong and reflects a juxtaposition of cause and effect. Excess deficits did not produce the crisis, but to the contrary the crisis led to the excessive deficits and debt problems. This is an important distinction that has been lost on most policy makers and observers. As recently as 2008, collectively the fiscal deficit in the euro zone was 2% of GDP. Last year it was 6.3%.

If fiscal excesses were the cause rather than the symptom, then the austerity cure might have worked. It hasn’t. We have made this point before, but it is worth repeating. Fiscal austerity in the periphery of Europe has not been rewarded by lower interest rates, reduced chanced of default (see credit default swaps) or greater investor confidence. Quite to the contrary; interest rates are higher, CDS premiums greater and investor confidence more fragile.

Although few observers have reached the conclusion yet, it may very well be the case that the austerity is exacerbating the crisis, making the stabilization of the key debt-to-GDP even more elusive. Of course, it is not as if America’s strategy of go-for-growth is without problems or costs, but those problems and costs seem preferable to the problems and costs of austerity. Growth does not solve all problems, but it makes addressing the problems somewhat easier.

Other Snake Oil

Monetary union is in its early stages of evolution. As such, it does not yet have the institutional capacity to address the crisis. Meanwhile, starting in 2013 collective action clauses (CACs) (which allow for orderly restructuring of debt) will be inserted in all sovereign bond covenants. On balance, this should help solve the problem and cure the debt stricken patient.

Yet the discussion of CACs is little more than a distraction, a mis-direction. If austerity is comparable to the medieval practice of bleeding a patient, collective action clauses are comparable to giving the patient a placebo. The fact of the matter is that CACs are not new. There have been past campaigns (mid-1990s and early 2000s) for their adoption.

Reports indicate that most sovereign bonds in peripheral Europe, including Greece and Ireland already have CACs or other features that allow for relatively orderly restructuring. Moreover, outside of Greece, it is private sector debt that seems at the heart of the matter. And officials have vast experience in restructuring private sector debt through bankruptcy or similar actions.

Some hope for a miracle; an exogenous factor that emerges to arrest the slide from liquidity to solvency. Whatever one might think about the differences between the West and East, the medicine China offers is clearly recognizable—money. As the man who is likely to be the next premier of China was touring parts of Europe (Spain, Germany and the UK) at the start of the year, hopes were lifted that China would use some of its largesse to buy peripheral bonds.

This too is ephemeral. Chinese officials are good guests and hosts. When they visit or are visited, commercial contracts alluded to are often signed. Some European press reports suggested recently that China may buy €6bln of Spanish bonds, which was said to be more than it had purchased of the other peripheral countries.

These sums are too small to materially affect the debt dynamics in the peripheral countries. China does keep reserves in euro denominated instruments. It has to invest those euros. Within its euro portfolio there may be a role for peripheral bond from some kind of statistical portfolio optimization model. Yet, if there is a restructuring, it would embarrass the Chinese officials that authorized it. Recall the criticism that was seen after China took stakes in Western banks very early in the crisis.

The medicine has been tried. Earlier last year, it was understood that China would consider buying Greek bonds and, as we have seen, it has not stopped the malignancy from growing and spreading. China might be a longer-term investor and stronger hands than some of the current holders, but there is no guarantee. Making allowances for the use of other financial centers and institutions, it appears China buys US Treasuries month-in and month-out, with a few exceptions here and there. Its purchases of Korean debt also seem fairly consistent of late. It purchases of Japanese paper seems more fickle.

It is not really in China’s interest to buy peripheral European bonds. It is in its interest to talk about and express interest. If it is going to invest serious sums, and not just the few basis points of interest on its more than $2.5 trillion of reserves it currently holds, wouldn’t it seek greater seniority than other unsecured creditors, and more in line with the IMF or EFSM?

The possibility of linkages to some trade issues, such as potential protectionism or the arms embargo, are unlikely to be secured for China by real or suggested investment in peripheral bonds. Indeed that fact that China may seek linkages could go in reverse too. If China is a holder of the bonds of a sovereign who seeks to restructure, then there is a risk that China would link its disappointment to some other issue even if unrelated. Lastly, as greater powers have long discovered and China will as well, using financial power to influence political outcomes is not always as easy as it sounds.

Europe is sick. A year into its illness it still has yet to properly diagnose its problems. The failure of the diagnosis is evident in its inability to find a cure. The fever will intensify. Portugal will succumb next. It may provide a new opportunity for institutional reform, as did the Greek and Irish crises.

If squandered, the contagion is headed for Spain. If this does indeed to turn out to be the case, then Greece, Ireland, and Portugal would be little more than a dress rehearsal. Accounting for around 10% of the euro zone’s GDP, Spain is bigger than Greece, Ireland, Portugal and Belgium put together. Nor would it need a new trigger, any more than Sisyphus’ rock. Gravity suffices. We might not like it, but it is the law.