Eurozone crisis – a constructive response

The eurozone crisis took a decisive twist last Thursday with the announcement of a robust package of measures, designed to deal with the very deep-seated problems in the region. Some market commentators had remarked that the eurozone was in the “last chance saloon” prior to the announcement. Indeed, the extent of the measures was an acknowledgement of the severity of the situation. The most important measures were as follows:

 The European Finance and Stability Fund (EFSF) will be able, subject to full approval, to buy debt in the secondary market, with approx EUR 300bn left.

 The EFSF will lend at the same rate as it borrows, i.e. 3.5%, for a minimum of 15 years rather than the 7.5 years at present. This effectively gives the periphery the debt servicing costs of a treble A-rated borrower.

 The principle of a private-sector bond buyback was established.

 A quasi Marshall Plan for Greece was announced, backed by the EU and European Investment Bank.

 The ECB will effectively repo Greek bonds following a selective default, which is an action it hitherto had refused to do

How do the measures address Europe’s problems? Credit Suisse has estimated that the private sector involvement will lead to a 21% decline in the net present value of Greek debt and a 10% decline in its debt/GDP ratio. This is clearly to be welcomed, but the 21% “haircut” still falls short of the c50% reduction that some analysts have estimated as being needed.

What the package has done is help to create a fire-break to avoid the spread of contagion throughout the eurozone. One of the big takeaways from George Soros’ book, the Alchemy of Finance, was his theory of reflexivity. At the risk of over simplification, the tenet of reflexivity is that reality shapes perception and perception then impacts on reality etc. In other words, a reflexive environment is basically a vicious or a virtuous circle...and the eurozone was in a vicious circle prior to Thursday’s announcement.

Fiscal sustainability calculations effectively compare the spread between long-term nominal GDP growth and current bond yields and the cyclically-adjusted primary budget balance. Taking this as a static exercise, then Greece, Ireland and Portugal were very stressed, barring the political will for many years of austerity (which could not be assured); Italy was fine while Spain had a painful adjustment. But the vicious circle meant that the perception of insolvency led to spread widening, which worsened fiscal solvency and thereby exacerbated the perception of insolvency – which was why the EU leaders HAD to act as they did.

What the authorities have not done. The authorities have made great efforts, but these actions should be put into a broader context. We have long believed that the eurozone crisis comprises three inter-related pressures – fiscal solvency, external competitiveness and banking system illiquidity (i.e. loan-deposit ratios well above 100%). What they have not done – and probably cannot do – is to improve the external competitiveness of the periphery of the eurozone. While these measures have helped to improve the debt servicing capabilities of the periphery, they have not resolved the deeper problems of competitiveness or the financing of current account deficits. Neither do the measures provide any reassurance about future growth prospects, which remain bleak.

In most banking crises of recent times, adjustment has necessitated a sizeable devaluation of the exchange rate, to improve export prospects and reduce the external deficit. This coupled with fiscal tightening has helped to rebalance economies. The euro remains significantly overvalued from the standpoint of the periphery and the reduction of the external deficits depends on domestic contraction (i.e. more pain). This would threaten tax revenues and thus feed into more fiscal solvency pressures. Moreover, the financing of current account deficits (which range from 4.5% to 9.5% of GDP in Spain, Greece and Portugal) probably requires short-term funding, hence worries about bank illiquidity.

What is still to be done? There are several other measures that should be considered. First, the EFSF should be bolstered further. One ECB governing council member suggested that the size of the EFSF should be limited to EUR 1.5tn, which would amount to 52% of the public debt of the periphery (including Italy). But further increases funded by the core eurozone economies would involve guarantees that would increase public debt ratios in those countries. Second, a euro bond would need to be issued with a European guarantee. Third, further haircuts are probably required – and not just for Greece. Fourth, the ECB will need to provide additional liquidity to the periphery banks, to enable them to fund their loans. Finally, the ECB probably has to enact another U turn and move towards an easier policy stance. Our currency team’s policy indicator suggests that the case for further interest rate increases is no longer valid.

Market implications. The measures demonstrate the commitment of the authorities within the EU to maintain and protect the single currency. Investors should also take account of this political commitment rather than to focus solely on the economic problems of monetary union. Early last week, prior to the announcement of the package, we eliminated our underweights in the periphery and moved to a small overweight overall in European equities. We interpreted price action at the end of the week as being largely due to short covering, especially in financials. Within Europe, we remain overweight in the core, especially Germany. We remain overweight equities and are now running slightly above average levels of risk in our balanced portfolios.