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Can the
euro be saved? Is it possible to stem the flight of money from the periphery
into the core? With a botched German auction in mind, investors are now wondering
whether it’s possible to prevent a flight out of “all things
euro”? We examine the dual challenges of fiscal
sustainability and bank solvency in this analysis, with the not-so-modest
title “Guide to Save the Euro”.
Fiscal
sustainability
Fiscal
sustainability is about revenue and expenses, but also about perception. As
the housing bubble in the U.S. proved, what is affordable at low interest
rates may become a nightmare when rates go up. Similar rules apply to
governments: if there is a perception that obligations won’t be paid
back, the cost of borrowing will skyrocket. Spain is the most recent case
study. Recent elections kicked out the socialist government, giving an
absolute majority to the party of conservative prime minister-elect Mariano Rajoy. You would think that Rajoy
would give a speech, declaring how his party will use its mandate to ensure
Spain’s obligations will be met, how the rigid Spanish labor market
will be opened up, how Spain – with one of the lowest debt to GDP
ratios in the developed world – will have a strong comeback. You would
expect his team would give an update on how to clean up the Spanish banking
system; how his administration will be transparent and give frequent updates
on progress. However, in an apparent proof that politicians globally are
utterly clueless about all things finance, Rajoy
pronounced in an interview that Spain would be unable to come to a sound
financial footing if it has to pay 7% on its debt. The market’s
response was swift: Spain had to pay 5.1% to sell 3-month Treasury Bills in
late November, versus 2.3% just a month earlier. While Rajoy
has lined up what some consider extremely competent people, he is not known
to make tough decisions. Overlay this with the concern that members of his
party are responsible for some of the policies that have led to the current
malaise and you can see why the market seriously questions whether there is
the determination to make the necessary tough decisions – decisions
that will likely step all over the toes of regional decision makers in his
own party.
But fear
not! The market will bring Rajoy and other policy
makers to their knees. By imposing punitive borrowing costs on Spain, the
Spanish government will get the message. The question then will be whether
the medicine will be too tough to swallow. Regaining market confidence after
destroying it is rather difficult. It took former Federal Reserve Chairman
Paul Volcker the herculean task of raising interest rates to 20% to convince
the market that he was serious about fighting inflation; in contrast, when
there is confidence, a Fed official only needs to utter a few words to
appease concerns in the market. Similarly, what would have historically been
a regular budget battle to balance the books may become a struggle for
survival.
To achieve
a sustainable budget, the obvious levers are to increase revenue or to cut
spending. As Greece has shown, raising revenue through tax increases does not
necessarily work; governments can also liberalize their labor market, cutting
red tape. They can sell off government property to reduce debt levels, but in
the absence of other structural reform, such sales might only be a short-term
patch up. The expense side, of course, is where real progress can be made.
All governments of developed countries face the risk that they have made too
many promises. Some of those commitments can be renegotiated in an orderly
fashion, others through default.
Policy
makers believe that if there is some magic elixir – such as an
insurance scheme or an unlimited Chinese checkbook, governments will have the
breathing room to clean themselves up. However, our dear policy makers have
proven that the moment the pressure abates, the willingness to push through
tough reforms evaporates. That’s not a European trait, but a universal
one: in the U.S., there is no pressure applied by the bond market and, as a
result, there is no agreement to tackle fiscal sustainability in the U.S.
What about
calling it quits, leaving the euro? We have long argued that it isn’t
in anyone’s interest to leave the euro. Take Germany: a currency
dragged down by weaker peripheral countries helps German exports. Germany is
effectively operating with an artificially weak deutschemark. More
importantly, if Germany were to leave the euro, money might be sucked out of
the financial systems of weaker Eurozone countries and into Germany, thus
exacerbating a collapse of the periphery. Just because this isn’t in
Germany’s interest, it doesn’t mean the market isn’t
pricing it in: in the third quarter, large Italian and Spanish banks reported
double-digit percentage declines in deposits from corporate and institutional
clients, although their overall deposit levels only dropped by approximately
2%.
Generally
speaking, there are two paths that may lead to fiscal sustainability:
surrendering sovereign control over the budgeting process; or, embracing the
brutal pressures imposed by the bond market.
Surrendering
sovereign control over budgeting process
When a
government asks the IMF to help, tough austerity measures are imposed, a de
facto handover of sovereign control to an outside agency. Keep in mind that
the IMF currently does not have sufficient resources to step in and rescue
Europe. It would require Europe and the US to swallow their pride and allow
China to chip in. China, in turn, would rightfully demand substantial voting
rights at the IMF.
When other
Eurozone countries impose terms, the process is similar, except that the IMF
has more established processes, i.e. is used to playing “bad cop”
when it comes to imposing highly unpopular reforms. The same can be said
should a fiscal union be introduced that many are calling for: for Germany to
agree on any fiscal union in which Eurobonds are issued, stringent rules are
likely to be imposed on beneficiaries of the proceeds of such bonds. The
fiscal union is already taking shape. The notable shortcoming is a lack
of defined process regarding how money will be deployed – unfortunately
this shortcoming in the current setup means that each flare-up in the crisis
is addressed with yet another patch.
As part of
a more formalized fiscal union, Germany may open its checkbook to bail out
the rest of Europe. That’s a tall order, but the market is starting to
price in that possibility. The recent botched auction where the German
Treasury was unable to place all of its 10-year bonds showed that investors
are now demanding higher rates of return to lend money to Germany. Just
recently, Germany’s 10-year bonds yielded less than 2%; as of this
writing, the yield has risen to 2.3%. While still low, it shows that
“fiscal integration” in Europe means that a yield conversion
won’t happen at Germany’s cost of borrowing level. Germany will
also have to get used to the idea that the German bond may have to give up
its benchmark status to a Eurobond alternative over time. To the casual
observer, this may appear like a natural step; in a world with large
tradition and even larger egos, these are steps on a rocky road.
Embracing
bond market pressures
There is
an alternative that policy makers must contemplate: embracing the brutal
pressure imposed by the bond market. It requires dealing with the reality
that low interest rates must be earned. It also means that governments have
to embrace the reality that they may have to renegotiate some of their debt,
i.e. default. Government defaults are nothing new. However, governments
should take great care that a government default does not lead to an
implosion of the financial system. Banks hold substantial amounts of
sovereign debt – a key reason why select banking shares are under
pressure in Europe.
However,
banks have one major advantage over sovereigns: they have access to central
banks. While sovereigns must go into the market to fund themselves, banks may
go to their central bank to obtaining funding. Banks also employ a business
model that by nature has substantial leverage. While the leverage makes banks
vulnerable, the banking model has two advantages:
- Central
banks can keep even a technically insolvent banking system afloat. Just
look at Japan in the 1990s. Similarly, the Federal Reserve (Fed) and
European Central Bank (ECB) can keep even zombie banks afloat as long as
they choose to.
- The
reason the U.S. Treasury injected money into the banking system in the
fall of 2008 (the infamous TARP program) is because the inherent
leverage employed by banks allows any capital injection to support a
high multiple of debt. Former U.S. Treasury Secretary Hank
Paulson’s bazooka was effective because it was applied to
bolstering bank capital rather than buying toxic securities outright;
the latter would have turned the bazooka into a water pistol. Similarly
in Europe, the focus must be on making Eurozone banks strong enough to
stomach sovereign defaults.
The
implication, however, is that by strengthening Eurozone banks, the sovereigns
are weakened. In the U.S., while it was a gargantuan task to convince
Congress to authorize TARP, a central treasury allowed swift action. The U.S.
is simply better at spending and printing money than Europe. The downside is
that the U.S. example proved so effective that no real reform took place (and
executives were able to reap large paychecks).
A bazooka
works when one has a bazooka to shoot. The reality is that in Europe, many of
the sovereigns are now so weak that a bazooka may save only the banking
system, not necessarily the sovereigns. Policy makers need to address this
reality: in the case of a government default, it should be managed in an
orderly fashion. Avoid a run on the banks by making bank deposits as secure
as possible.
More
practically, it also means that France, for example, must sacrifice its AAA rating
in order to bail out its banks. It’s not really a sacrifice, as that
rating will be stripped in due course anyway, but politically it’s a
tough sell. That’s where the practical limitation of the self-sacrifice
approach lies: sovereigns will be most reluctant to intentionally blow a big
hole in their own shaky balance sheets to save the banking system.
As a
result, expect a muddled combination of increased IMF support, increased
fiscal convergence, increased focus on strengthening bank balance sheets,
increased involvement to keep banks afloat (the ECB is already debating
providing multi-year unlimited credit lines), and increased cost of borrowing
for Germany. However, this is likely to remain a drawn out process and the
tail risks that European policy makers mess this up cannot be ignored,
either. We come back to our initial argument: a lot depends on perception.
Perception is a function of leadership and a credible path that is likely to
lead to results. The prime minister-elect of Spain wasted his first
opportunity to make a good impression. The German psyche has been badly
wounded by the botched auction. In typical European fashion, another summit
has been announced to discuss closer fiscal integration. In case anyone
wonders why this process is so painful, it is because the right decisions are
politically so incredibly difficult to make.
Axel Merk
Manager, Merk Hard Currency Fund
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