What Next for Europe – Olly Russ – March 2011
Olly Russ, manager of the Ignis Argonaut European Income Fund and Enhanced Income Fund, explores the options available to the European finance ministers as they decide which track to take to tackle the challenges posed by sovereign debt.
The EU is currently up to something to solve the current debt crisis in the EU. The problem is twofold: one of liquidity in the first instance, and solvency (i.e. long term solutions) in the second.
Currently, EU troubled governments – Greece, Ireland, Portugal and potentially Spain (although this is a very different case) all suffer from very high current deficits, and in the first three, large piles of debt. In fact, some are not so very different from the US on current numbers, but without the ability to print currency and a high degree of market scepticism towards their intent/ ability to repay those debts, it has become increasingly difficult for them to fund themselves. As interest rates demanded by the market for sovereign debt skyrocket, so do interest costs, further destabilising the budget deficit, leading to higher interest rates, and so on in a vicious circle until default.
Japan survives with a very high level of debt and a very high current deficit, but with super-low interest rates, partly due to their large pools of domestic savings (not dependant on foreigners) and also ultimate ability to print money. Remember that if the EU went down the Fed/ BoE route, they would simply print money to cover the problem.
Given that is not an option (the Bundesbank would go ballistic), what can they do?
1) Default: a political decision right now, because there is sufficient funding available from the EU to last 3 years. A conscious default or debt-rescheduling, whereby coupons are forcibly lowered or maturities extended could help. But there has not been a default in Western Europe since 1947, and such is the interlinked nature of the European (inc UK) banking systems that such an event could make Lehmans look like a tea party. A 30% default by the PIGS would destroy the banking system of Western Europe, including that of Germany. In a default situation, access to capital would be severely restricted. Advanced nations have far too much at stake to risk a default except in extremis, as opposed to emerging markets where financial leverage and the banking sector are smaller. Default within the Euro would raise financing costs but not lead to devaluation – the pain without the gain.
2) Leave the Euro: as advanced by the racier anti-EU tabloids such as the Telegraph. Leaving the Euro in and of itself does nothing. Debt is still denominated in euros, still in an unprintable foreign currency. Devaluation, however, would mean it would soar in real value overnight – a 30% devaluation of say New Drachma would bankrupt Greece in a day. And who, if not the ECB, would then lend them money?
3) Problem is not insurmountable: To stabilise gross debt by 2025, Greece Portugal and Spain all need to make fiscal adjustments below the OECD average – and lower than the UK – roughly 5% of GDP. Ireland is 7%. Each problem varies substantially – the overall level of debt, the interest paid, the debt trajectory, demographics, the public/ private balance all play their part as to whether debt levels are sustainable. There is an element of mutual dependency – were one government to default, the market would assume all troubled states will, radically repricing the bond market downwards for most nations.
4) EU Governments have set themselves a deadline of 24-25th March to reach some kind of solution. According to Morgan Stanley, proposals include:
i) An increase in the guarantee ceiling of the EFSF (European Financial Stability Fund) from EUR 440bn.
ii) An increase in lending capabilities
iii) Short-term credit lines
iv) EFSF to buy bonds outright
v) Funding of debt buy-backs
vi) Reducing the interest rate of the EFSF loans
vii) Direct capital injections into the banking systems
The last four are the most interesting. If the EFSF buys back bonds on its own account, a haircut suffered purely in these bonds will not be a market event – no private holder will be affected. The Central Banks of Europe will take the hit. This is one way to soften the blow.
EFSF could make loans available for states to buy back and cancel debt, effectively replacing long-term costly finance with cheaper money
Reducing the interest rate on loans (currently around 7%) would definitely help. Greece is almost back to primary surplus (before interest payments) – it is the spiralling costs of debt that prevents them getting back in the black. A circuit breaking low rate of interest (say 5%) would be enough.
Capital injections would stabilise the banking system against sovereign default.
A further idea is the issuance of a Eurobond for the whole Eurozone – this is very unlikely.
Obstacles include:
The German government, unwilling to be seen to be bailing out the profligate. Although note that the crisis could now spread to Belgium, with over 100% debt to GDP levels, and the very heart of the EU. The old narrative of virtuous north supporting feckless south doesn’t really work now.
As a quid pro quo, two ideas have been floated – a draft law on macro surveillance by the EC, and a Franco-German competitiveness pact for the Eurozone.
The first idea involves macro monitoring and potential sanctions for breaking the rules. The second includes the idea of a Fiscal Rule (bit like Gordon’s Golden rule, only real), which says the budgets must balance over the cycle. This is a first step towards fiscal integration across the Eurozone.
The Market Response:
So far, the EU has wandered about chucking buckets of cash over the fires, in the hope the situation stabilises. Now a more long-term solution is needed, before the market goes critical. The strong performance of financial stocks year to date is to some degree predicated on this.
Unfortunately, the outcome looks somewhat binary. Reducing the interest rate or repurchasing loans will have a meaningful and long-lasting impact. Anything short of this is a disappointment.
In that event, we move swiftly I would imagine to the next crisis country – Portugal, where bond yields are currently as high as they have ever been in the current crisis. In absolute terms, it’s smaller than Greece, and the market is showing signs of crisis fatigue – if after all, local companies aren’t affected, should we care? We are not bond investors, and the Greek rate of corporation tax has actually come down. As the crisis grows ever closer to Brussels, eventually the EU would have to act. The consequences of not acting means the complete break up of the Eurozone, the EU banking system and whole EU project. As vested interests go, that’s a biggie.
If on the other hand they positively surprise – stranger things have happened, although you would have to go back to the spontaneous combustion of the Mayor of Warsaw in 1483 – then markets, especially peripheral financials will rip.
Either way, it’s worth waiting for the outcome, but they will ultimately find a solution – the result of not doing so is too horrific to contemplate. And curiously, the example of Greece in terms of fiscal adjustment is actually rather heartening. For us to do what they have done would require George Osborne to double his cuts – try doing that without riots.