Market Commentary
by Byron Wien
 
06/05/2012

Into the Weeds of the European Debt Crisis

I have just spent two weeks talking to our clients in Asia. Starting in Tokyo, I traveled to Seoul, Beijing, Hong Kong, Taipei, Singapore and Sydney. My objective was to better understand what was happening in the economies in the region, but I found that everyone wanted to talk about whether the European Union and the euro would survive. The Chinese were worried because Europe was an important market for them and everyone else was worried because their major exports were to China and if China slowed down seriously, they were in trouble.

So far the impact has not been too severe. Japan's first-quarter real GDP came in at 4% and auto sales are strong. There is a question about whether the improvement is sustainable because government expenditures to rebuild the area damaged by last year's earthquake have played an important role in the growth of the economy. Recent data on unemployment and retail sales have shown signs of softness. China still appears to be growing at a better than 8% real rate. In China, the Purchasing Managers Index has been below 50 for several months, casting doubt on the thesis that China will only have a “soft landing.” This is important because China is clearly the engine of growth for much of the world, consuming a third to more than half of a number of major industrial and agricultural commodities. Another worry in China is the soft housing market, where prices are declining in three-quarters of the 70 major markets. The big disappointment in China is the lack of economic rebalancing away from state-owned enterprises producing goods for export and from infrastructure spending towards a greater role for the Chinese consumer. The government is easing monetary policy and providing consumer spending incentives, and I remain optimistic that China will grow at about an 8% real rate in 2012.

Some are arguing that the reason the European Union is in trouble is that it was a bad idea in the first place. In the post-war period, when the United States dominated the world economy, the leaders of Europe looked across the Atlantic and dreamed of creating an alliance that would make their continent as economically powerful as America. Jean Monnet, one of the strongest advocates for European integration, said, “There will be monetary union in Europe or there will be no Europe.” In fact, the framers of the Maastricht Treaty of 1992 conceived of a political as well as a monetary union, but that proved too much to swallow at the time. Recognizing the problem that might be caused by a fixed exchange rate across countries of differing economic strength, critics like Milton Friedman and Martin Feldstein believed the project was doomed from the start, but the European Union moved forward with varying degrees of success until the financial crisis of 2008, when its weaknesses began to become painfully apparent.

The Bank Credit Analyst (BCA) has taken a look at the performance of the European Union in achieving its objectives since its inception. Their study concluded that intra-region trade flows did not improve as expected. For each member country, trade with the emerging markets expanded sharply, but that would probably have happened anyway. BCA also looked at investment spending. France alone saw an improvement in non-residential spending. Residential investment in Ireland and Spain did increase significantly after the common currency came into effect, but housing came to a bad end in both places. The European Central Bank was able to dampen inflation across the continent, but the objective of similar economic performance for the member countries failed to be achieved. This was largely because of the reforms instituted in Germany but not in other countries, which resulted in rising labor costs in the periphery and declining competitiveness. This exacerbated balance of payments problems in the southern countries.

Yield differentials across members of the European Union were small before 2007, which was seen as a sign of economic convergence, but as the current head of the European Central Bank, Mario Draghi, has pointed out, this was not an indicator of financial integration; “it was, in fact, a sign of a systemic underpricing of credit risk.” Another hoped-for objective, cross-border lending among financial institutions, did not take place. While the conclusion from this analysis is that many of the hoped-for objectives have not been achieved, the European Union has forced its members to consider the possibility of fiscal integration and to recognize the perils of profligate internal financial management. In my view, with all of its problems, Europe is in a better competitive economic position than it would be if the European Union had never come about. France, Germany and the Netherlands have been the winners.

But what happens now? The most immediate challenge is that the banks of the weaker countries are facing a rapid withdrawal of deposits, or a “run.” The reason for this is the fear that if the European Union breaks up and the euro ceases to exist, the deposits in Greece, Portugal, Italy, Ireland or Spain might have only half the purchasing power if they are converted into the new local currency. Greek banks have lost 17% of their deposits over the past year and the outflow continues. Depositors are moving euros primarily to Germany, where they consider the banks to be safe. They are also converting euros into dollars, which has accounted for the recent strength of the U.S. currency. Since 2007 over €600 billion has been moved out of the so-called PIIGS and into Germany, according to a report by Gavyn Davies. One way to stop this would be for the European Central Bank or some other institution to offer a guarantee on all Eurozone bank deposits, as Mario Monti has suggested. This would only work if the authorities were able to assure depositors that the euro would continue to exist.

The Greek situation may have a parallel in the decision to force Lehman into bankruptcy in 2008. The firm had opportunities to sell and held out for a higher price. In its final days it was insolvent and needed funds to continue operations. It could have been eased into a gradual liquidation with about $10 billion of additional capital. Instead it went bankrupt, destabilizing the entire banking system and creating perhaps $100 billion in damages to other institutions. If Greece defaulted now, the cost estimates range from several hundred billion euros to over a trillion because of contagion. Perhaps by providing more liquidity now and buying more time to adjust to the inevitable dislocations caused by Greece leaving the Union, Europe and the rest of the world would be better off.

Whether Greece is able to convince other members of the European Union that it will try to implement some of the required reforms may depend on the outcome of the election on June 17. Polls show that most Greeks don’t want to leave the Union and give up the euro because they sense the chaos that might cause. Even if the far left party gains political control of the country, it is likely that some compromise will be negotiated that will give Greece the necessary funds to enable the government to continue to function. This brings up the “moral hazard issue.” Should Greece be allowed to continue to be a member of the Union if it repudiates the financial discipline that had been asked of the country in exchange for financial support? I believe Greece will go partway towards meeting the requirements no matter who wins on June 17 and the leaders of the Union will provide aid because the implications of Greece leaving now are so severe. What happens next year is more problematic.

It has been my belief since the crisis began to develop in 2010 that every effort would be made to preserve the European Union and the euro as its currency. The only change in my thinking is that I recognize that the financial problems of Greece and, to a lesser extent, Portugal, may be so great that long-term membership becomes more questionable. If Greece were to default, banks across the continent would be hurt, but the sovereign debt of that country has already been written down substantially, so the incremental pain might not be that great, although fear of contagion to other weak countries would be more serious. Moreover, the Greek economy accounts for only 2% of the Eurozone, so it is hardly a major factor as a trading partner. Even if Greece left the Union and devalued its currency, its economy might not improve that much. It has no broad manufacturing base, but it does have a potentially vibrant tourism industry and some of the best olive oil in the world. Its trade deficit is more than 10% of GDP and its economy is contracting at better than 10% with unemployment above 20%. A cheaper currency will not correct all that. Tourists may be attracted by the cheap prices, but the social unrest that is likely to develop from bank failures and inflation may put them off.

The countries key to the survival of the European Union are Italy and Spain. I am particularly optimistic about Italy because Mario Monti has successfully introduced reforms that have reduced bloated government expenditures and made businesses more efficient. Italy has a large debt to GDP ratio but its budget deficit is more modest. Spain also has a relatively small budget deficit but it has many bad loans on the books of the banks as a result of the real estate boom in the last decade. Spain also has a major unemployment problem, especially among its youth. Both countries have viable manufacturing bases and products that have acceptance in the world markets. Their current account deficits are manageable. In an encouraging show of strength and independence, Spain turned down financial aid for its banks from the so-called “troika” (the European Central Bank, the European Commission and the International Monetary Fund) because it didn’t want the regulatory organizations meddling in its financial affairs.

If you look at the major economies of Europe, they can be split into two groups. The countries with positive growth – France, Germany, the Netherlands, Belgium, Luxembourg and Finland – also have positive current account balances. The countries with negative GDP have current account deficits. This is why the concept of austerity is so dangerous. The only way Europe can move forward is through a combination of growth and time. If the countries experiencing current GDP contraction are forced to implement severe austerity programs, it is hard to see how they will gain enough strength to achieve long-term viability. The leaders of Europe seem to recognize this. François Hollande of France has proposed eurobonds as a way to finance members through the transition period; Angela Merkel of Germany is against the idea but seems to be backing away from her hard stance in favor of austerity as she recognizes the risks that policy represents. I don’t see eurobonds being introduced any time soon but I do see austerity demands being relaxed.

What is happening in the rest of the world is relevant to Europe's future. The United States, Latin America and Asia are major markets for its products. It is important that the United States grow about 2.5% and that China has a “soft landing” in 2012. Other emerging markets have to continue growing in the range of 4%–5% so that they will continue to demand European products. I believe the rest of the world outside of Europe will meet its growth targets. I know the recent data have shown signs of weakness everywhere, but I believe we will see stronger performance in the second half.

The most encouraging aspect of what's happening in Europe is that the leaders of the important countries are desperately seeking a solution to the current problems. They know they have more to lose than to gain if the European Union dissolves and they go back to their national currencies. The dream of a unified Europe may have been overly idealistic, but we cannot turn back the clock. Everything must be done to make it work. I believe the institutions needed to accomplish success are in place. The European Central Bank has done a good job so far but it can only provide temporary relief to the financial system; it cannot implement the necessary structural reforms. Other financial institutions that exist or have been put in place can also provide transitional assistance, but it is up to the countries themselves to undergo the constructive changes that will enable them to move forward and grow. The risk is that populist unrest makes the implementation of reforms impossible. We have seen signs of that in Greece and elsewhere. We have to hope that social unrest doesn't overwhelm sensible policy changes.

At the beginning of the year investors were cautious because of the budget problems in the United States and concerns about a weak economy going into 2012. They were also worried about the pace of growth in the developing countries and the sovereign debt crisis in Europe. That apprehensive mood was a perfect platform for a market rally and the Standard & Poor's 500 reached 1400 before the end of March. By then the United States economy had improved (partly because of unseasonably good weather over the winter) and investors were optimistic. Conditions were ripe for a correction and almost anything could have precipitated it. Europe provided the trigger. Now almost everyone seems negative again. The poor May unemployment report in the U.S. could produce the final capitulation.

We may have somewhat further to go in the decline, but I believe the outlook is improving. Three-quarters of the world's GDP is in a growth mode. Inflation is low and the price of oil is coming down. Europe is searching for solutions to its problems. I believe there will be a move towards compromise and productive legislation on the budget deficit in the United States no matter who wins the November election. I am nervous but optimistic about the remainder of the year.

 

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