Betting on the unthinkable in the euro zone
Some crises bring partners closer together. Some, as investors in the euro zone are likely to discover this year, drive them further apart.
Look for rising tensions about fiscal and monetary policy among the bloc’s 16 member nations, and for a bigger penalty to be imposed on the euro and some euro zone assets against the possibility of a breakup or a secession from the currency group.
The liquidity crisis of last year left smaller members of the euro thanking their lucky stars they were inside a big warm tent with a major currency and critically, a powerful central bank that could help banks and maintain order in financial markets.
Ireland and Greece, to name but two, could look at the disaster in Iceland, which suffered a banking and currency collapse, and see the real tangible benefits of membership.
But now that the crisis has morphed into one in the real economy, with exports plunging and employment hit, things will be less cohesive within the euro zone, with one currency having to do duty for different countries with different economies and levels of competitiveness.
European governments vary widely in their ability to withstand the fiscal squeeze from falling tax receipts, as well as having varying ability to credibly take on programs of stimulative deficit spending. That of course is about all that euro countries have open to them when it comes to unilateral action, being forced as a condition of membership to live with a common currency and interest rate policy.
The ECB is widely expected to cut rates by a half a percentage point on Thursday, to 2.0 percent, a level considerably higher than the ideal for many hard hit smaller economies.
The implication is weakness for the euro, as investors impose a breakup premia, and more weakness for the bonds of smaller peripheral countries.
Standard & Poor’s on Wednesday cut Greece’s sovereign debt rating, citing falling competitiveness and a rising fiscal deficit. S&P has also threatened the credit ratings of Ireland, Portugal and Spain on concerns about deteriorating public finances.
The extra interest Greece must pay to borrow money for 10 years as compared with Germany stands at 246 basis points, while for Ireland the figure hit 180 basis points, also a record, and spreads have widened too for Spain and Portugal. Coming at a time of low interest rates, with German 10-year debt yielding just over 3 percent, these are whopping premiums for debt that theoretically should be very tightly related.
CHEER UP, IT MIGHT NEVER HAPPEN
To be clear, the chances of a country leaving the euro zone currency project are still extremely small, though it now rates as a possibility for discussion in polite company.
For one thing there is no escape hatch, no plan as to how a national currency might be reborn. For another, there is the matter that while a bit of a weak currency and an accommodative interest rate might seem attractive at first blush, the reality would include much higher interest rates and the real risk of a Latin-American style inflation and currency crisis.
“Put very simply if either Greece or Italy, for example, left, the sort of spreads they are trading on at the moment would have to treble,” said Marc Ostwald, strategist at brokerage Monument Securities in London.
“There would be colossal inflation in both countries as a result.”
It would also be extremely tricky to pull out without very seriously impairing your national banking system, though that impairment may come of its own momentum anyway, conceivably as the flash point for a break-up. But just because something is a dumb idea doesn’t mean it won’t be advanced as reasonable.
There are other issues causing problems for countries with smaller bond markets. Investors are generally showing an almost unprecedented preference for stuff that is easy to sell, and German bonds are just a lot more liquid.
You can also argue that the kinds of very narrow spreads we saw before the crisis were simply one more manifestation of the headlong search for yield, and that some but not all of the re-pricing is warranted as a reflection of the new reality.
There are a couple of bitter ironies here for the euro zone. The world has probably never needed an alternative reserve currency more, with natural demand likely to rise for liquid, safe non-dollar assets given U.S. imbalances and monetary policy experiments.
It is also a bit raw that the downturn that will test the euro zone is not of its making. Its consumers by and large didn’t gorge at the debt feast and savings rates remained on the whole higher.
But that is cold comfort and no assurance the price of the risks of euro disintegration won’t rise further.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.