Guide to Save the Euro
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 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, Portfolio Manager, Merk Funds