Submitted by Alex Gloy of Lighthouse Investment Management
Funeral music for the Euro-zone?
This week, EU leaders will try to agree on limited EU treaty changes
at a summit (December 16-17). The aim is to establish a permanent rescue
mechanism for countries in financial difficulties. On Monday and
Tuesday (December 13-14) foreign affairs ministers will meet in Brussels
to prepare draft conclusions. The BBC claims to have obtained a draft
communiqué. We will analyze if a new European Stability Mechanism (ESM)
has any chance to save the Euro.
It will be interesting to see how far the idea of eBonds
(supra-national bonds issued by the EU to funnel money towards countries
in difficulties) will get amidst opposition from the two largest
contributors – Germany and France.
It is unclear why it took a French-German summit
to state the obvious, namely that bankrupt entities, including
sovereigns, should be allowed to go bankrupt. “Bankrupt” not as in “the
end of the world”, but rather as a way of making a debt problem
manageable by restructuring it. Orderly bankruptcy proceedings, by the
way, are in the interest of creditors (since otherwise creditors would
create more damage in a “first-come-first-served” rush to secure
collateral at the detriment of others).
After peripheral European bond spreads exploded, Ms. Merkel tried to
limit the damage by assuring investors that no haircuts would have to be
borne until mid-2013 (when the European Financial Stability Fund – EFSF
– is supposed to be terminated). In a desperate attempt to calm
markets, European finance ministers
specified “that this does not apply to any outstanding debt”. But what,
should the Euro-zone still exit in 2013, would that mean in practice
(apart from the effect of having a two-tiered bond market)?
Euro-zone politicians to taxpayers: This mud-pie to hit your face by 2013
Sovereign bonds with issue date before mid-2013 would be “exempt”
from restructuring? Who in his right mind would venture out to buy bonds
issued by a heavily indebted country after that fatal date? Obvious
answer: nobody. Even if that country managed to sell a few new bonds –
those bonds would make up only a small percentage of total debt
outstanding (but would have to bear the full burden of haircuts,
dramatically impacting expected recovery value). Even if such an event
was to occur – how much debt relief would the issuing country gain (if,
say, 99% of bonds outstanding have been issued prior to mid-2013 and
hence will not suffer haircuts)?
This plan is not only half-baked, it is akin to a pile of sand and
mud mixed together by a couple of 2-year olds and presented to their
parents (the taxpayers) as a “beautiful cake”.
Euro-zone taxpayers might be in for another surprise. As Irish bond
yields kept rising even after the EUR 85bn bail-out was announced the
European Central Bank (ECB) bought Irish, Greek and Portuguese
government bonds in earnest. What will happen to those holdings in case
of a default? According to a statement by the Euro Group
(meeting of finance ministers of the Euro zone) an ESM (European
Stability Mechanism) loan “will enjoy preferred creditor status, junior
only to the IMF loan”. FitchRatings agency warned:
“The preferred creditor status of ESM lending and therefore the
subordination of private creditors’ claims could result in lower ratings
(…)”. While arguments can be made in support of seniority of ESM loans
(it is, after all, taxpayers’ money used to bail out other countries)
this has other consequences:
1. Crowding out of private investors: Private investors are being
subordinated (which alone should lead to rating downgrades and further
losses for bond holders). This will make their participation in future
government bond sales even less likely. ESM bail-outs effectively make
it more difficult, not easier, for a sovereign to access capital
2. Stealth shift of restructuring burden onto taxpayers: By loading
up on sovereign government bonds the ECB becomes a subordinated creditor
of over-indebted countries (not even mentioning ECB lending to
insolvent banks). Since the bonds are being bought in the secondary
market at steep discounts to par value the ECB is unlikely to be able to
claim same creditor status as ESM loans. Should a bailed-out country finally default, the ECB might be left holding the bag, with the taxpayer footing the bill.
This opens an entire different thought: what if “strong” countries left the Euro ahead of
any sovereign bankruptcies? Surely those countries would set up their
own central banks and could leave countries stuck in the Euro-zone to
share ECB losses amongst themselves. There might be a “first mover
advantage”, as those who stay until the end of the party usually are
being recruited for cleaning up the mess.
While Euro Group claims to act in the interest of taxpayers (“…in order to protect taxpayers’ money”)
they achieve the opposite. Bail-outs are neither in the interest of the
recipient (i.e. Ireland, as only more debt is added to an already
indebted creditor), nor in the interest of taxpayers in contributing
countries, nor in the interest of bond holders (subordination). The
question may be raised in whose interest those bail-outs really are.
Many fingers point towards French, German and British banks who risk
becoming insolvent should their foolish loans go up in smoke.
De-leveraging (reduction of debt levels) leads to lower GDP growth
and, possibly, to deflation. As seen in Japan, nominal GDP will trend below real GDP.
As debt is supported by nominal GDP, deflation makes elevated
debt-to-GDP ratios more difficult to bear. I doubt there is any chance
for Ireland to achieve the overly optimistic GDP growth numbers of its
National Recovery Plan (“The Plan projects that real GDP will grow 2.75%
on average over the 2011-2014 period”), and any spells of deflation will make the situation only worse.
Can the Euro be saved?
It seems politicians in the Euro-zone are trying to save the Euro by
shifting the burden of debt restructuring onto taxpayers and allowing
enough time for financial institutions to get rid of their loans.
Reduced debt levels would give a couple of years of “breathing room”,
but not address the problem of diverging trends in unit labor costs and
trade balances. It would merely postpone the unavoidable. As argued earlier,
a Euro exit would lead to the same “punishment” as bankruptcy (elevated
interest rates and limited capital market access) for a limited period.
It should be noted that yields of some countries government debt (i.e.
Greece) have already reached levels more consistent with the event of
re-introduction of their own, weaker currency.
Apparently Sarkozy threatened leaving the Euro in May (in order to
force Germany to accept the 750bn bail-out). This was clearly an empty
threat, but with Merkel partying with Putin in Moscow and the German
finance minister hospitalized the Germans took the bait.
Mrs. Merkel plays her highest card
Recently, The Guardian reported Mrs. Merkel to have threatened the same
at an EU summit in Brussels at the end of October. Now, it is unlikely
the author suddenly found out about this threat more than a month after
the incident. Instead, it looks like an aide to Mrs. Merkel leaked this
information to a British newspaper (more credible than a German
newspaper). Threatening to leave the Euro is, of course, the highest
card Mrs. Merkel can possibly play. Playing the highest card smacks of
desperation and reveals huge differences among European politicians. Of
course, if everybody threatens to leave the Euro, that threat loses its
effectiveness. We might already have entered the end game.
The end game: Which one is the least chaotic option?
Assuming the end game is a break-up of the Euro-zone, which is the least chaotic option?
Imagine a single “weak” country leaving the Euro-zone and introducing
its own currency. Bank depositors would face a forced conversion of
their Euro savings into the new, weaker alternative. A bank run (into
gold or Euro deposits at banks in other countries) would be guaranteed
to ensue. Bank runs could destabilize other indebted countries, too.
However, should Germany (plus Netherlands, Finland?) quit the Euro
zone and introduce their own respective currencies, the majority of
savers in remaining Euro-zone countries might think twice before moving
their savings into new and unproven currencies. Of course, a New
Deutschmark would appreciate versus the “Mediterranean” Euro and lead to
problems for German exports. But those companies could be compensated
by currency gains stemming from paying old Euro debt with New
An independent Germany would surely want to have back its Bundesbank –
which would compete directly with the ECB (and I would not expect the
ECB to be keen on such an outcome).
The stakes are high. Even the IMF has gotten cold feet ahead of the
vote by the Irish Parliament on the EU-IMF Financial Assistance Program
(December 15th) and delayed a vote by its own board until the 16th. A
“no” from Dublin would be a significant blow for the Euro – but a huge
win for Irish taxpayers.
Alexander Gloy is founder and CIO of Lighthouse Investment Management
Merkel and Sarkozy concluded at a meeting in Deauville on October 18
2010 that future rescues of Euro-zone states should involve losses for
private bond holders.
 G20 meeting in Seoul, November 11-12, 2010.
 Sovereign bonds of, say, Ireland would trade at different yields depending on their issue date.
 Statement by Eurogroup, November 28, 2010, page 2
 “Contagion, Support and Euro Area Sovereign Ratings”, Comment, by FitchRatings, December 2010
See “The seniority conundrum: Bail out countries but bail in private,
short-term creditors?” by: Daniel Gros, Center for European Policy
Studies, December 5, 2010
 Statement by Eurogroup, November 28, 2010, page 2
Real GDP growth = nominal GDP growth minus rate of inflation. If
inflation is positive, real GDP growth is lower than nominal GDP growth
(and the opposite in case of deflation).
 “The National Recovery Plan 2011-14″ leaflet, page 1
 “Angela Merkel warned that Germany could abandon the Euro” by Ian Traynor; in: The Guardian, December 3, 2010