Euro Zone, part 1,000,000,000…

The only issue of interest remains the EZ,so here goes. However, I will point out that analysts continue to downgrade China’s GDP forecasts – still way too high, which suggests to me that China will have to take additional measures to stimulate their economy.

At present, Spanish 10 year bonds are trading at 6.96% (having briefly traded around 7.0%), up 21bps on the day – Moody’s downgraded Spain to Baa3, from A3 today, with a warning that it could be downgraded further in 3 months. Historically, EZ countries have had to seek a bail out at yields around 7.0% – no real reason for this number/level, but it is important, as its in the mind of market participants. As you know, I believe it is inevitable that Spain seeks a bail out – its being (indeed has been) priced out of international capital markets. The E100bn (will need to be increased) bank bail out is also insufficient. With Spain requiring at least E400bn by 2014, and with the ESM (which requires funding from a number of EZ countries) with funds (assuming full contributions from EZ countries including, at present, from Spain !!!!), of just E500bn, the current situation is untenable. Yes the EFSF boosts that’s number, but the funding available remains insufficient for the task required. As a result, there are really only a few options, namely (a) that the ECB buys peripheral country bonds or (b) the ESM is expanded, with EZ countries increasing their capital contributions – unlikely given that most contributing countries are unable/unwilling to increase their contribution especially as Spain, a major contributor, will not be able to cough up, or (c) the ESM is granted a banking licence or (d) Euro Bonds.

The ECB does not want to reenter the markets and buy peripheral debt – it believes (rightly in my opinion) that this is now a crisis which requires political/policy action. To date the politicians have relied on the ECB (an excuse to do nothing), but this is untenable and, as Draghi quite rightly points out, is not the ECB’s task. Having said that, I do believe that the ECB will have to act if the situation spins out of control (quite possible) – there is no alternative. However, ECB action is not a long term or even a medium term solution, for that matter – the EZ still needs policy action. In addition, the fear of private sector subordination (to bonds bought by the ECB) will result in Spanish bond yields not declining by as much as would otherwise be the case, in my humble view, making ECB buying somewhat futile.

Various analysts/newspapers have suggested that Germany will cave in and agree to issue Euro Bonds imminently – personally, I believe that this is misguided, indeed completely wrong/pie in the sky stuff. Neither will Germany, in my humble view, agree to an EZ wide bank deposit guarantee scheme, though they may make offer some generic remarks/ gestures towards a banking union in due course (probably at the 28/29th June EU Heads of State meeting). They may even, in generic terms, talk about the issue of Euro Bonds, but only when conditions are right ie after sufficient fiscal measures are enacted.

The idea of a bond redemption fund seems to be off the agenda, as well. An EZ wide bank deposit guarantee scheme increases German exposure materially and, in addition, is being resisted by the politically powerful German banking lobby. As a result, the only available alternative (other than a bust up of the EZ) is for the ESM to be granted a banking licence, in my humble view. Yes the ECB (in the past, though seems to be less opposed, at present) and Germany are allegedly opposed, but what alternative is there – pray tell me. Today Mrs Merkel stated that there would be “no miracle solutions”. Remember those words – she means it. Yesterday, in a speech to the German Parliament, she dismissed the idea of Euro Bonds and/or an EZ wide bank deposit guarantee scheme. Everyone expects Germany to bail out the EZ says Mrs Merkel. However, the bottom line is that even if it wished to, Germany cannot – it does not have sufficient firepower. Mrs Merkel added “Germany’s resources are not unlimited” – too true, Mrs M.

The ECB has held off reducing interest rates till after the outcome of the Greek elections is known. However, I have no doubt that the ECB will reduce interest rates (by at least 25bps) imminently, especially as inflation continues to decline in the EZ. Whilst helpful, it will not be enough – the situation has moved far too far for such measures to have any meaningful impact. As for Greece, I remain of the view that the New Democracy Party will gain the highest % of votes in this Sunday’s elections, with Syriza coming in 2nd. A week or so ago, I was convinced that New Democracy would win, but with the EZ making noises that they would renegotiate the previous deal with the Greeks (sort of changing its mind today), voters may move to Syriza, on the view that Mr Tsipras will get Greece a better deal. However, I remain of the view that New Democracy will return as the largest party – 65%+ chance, though down from 80%+ a week or so ago.

The reality is that Mr Tsipras wont be able to negotiate a better deal (he is delusional) and if he is in power and maintains his current position, Greece will be out of the EZ pretty soon thereafter. If New Democracy wins and can form a coalition, there will be some give from the rest of the EZ, but the Greeks will never deliver, which suggests to me that they will be forced to exit, but a little bit later.

The key issue remains, namely avoiding contagion spreading and I can only see that being put in place with a much larger ESM ie granting the ESM a banking licence. OK, the Germans will not want to monetise debt – they will demand strict adherence to a (revised) fiscal compact, and in addition, they have issues re their Constitutional Court. However, the current budget targets are impossible for virtually every country to meet. If access to ESM funds is contingent on EZ countries meeting their (revised) fiscal targets, the result will provide Germany with its desired outcome – cutting expenditure and imposing fiscal discipline, which, of course, will require structural (including labour) reforms and, ultimately, tax harmonisation – sorry Ireland, though the concept of fiscal transfers to less well off countries will also have to be put in place.

The EZ is heading towards a fiscal union, which means a political and transfer union – very much similar to the US. Sure it could bust up before that, but I believe that, kicking and screaming, it is heading that way. This are the key German requirements. Yes, there will be some growth measures introduced, but the thought that an expanded EIB can finance infrastructure projects (most countries do not need more infrastructure and it will take time) which will make a difference, is a clear nonsense. The cost of an Euro break op is way in excess of keeping it together, flawed though it is. I have been a committed Euro sceptic forever – however, I believe there is no choice but to retain the Euro, for the vast majority of EZ countries – the UK, well lets remain well out of it for quite some time. The alternative, well I’ll be bagging the first decent cave.

I gave a lecture to a number of US business school students who are in London. By a margin of 4 to 1, they believed that the Euro would survive, though not necessarily with the current 17 members. Interesting and, indeed, surprised me, I would have thought that they would have been far more Euro sceptic..

Germany will have to concede on the tough austerity measures it is proposing – indeed, some growth measures will have to introduced. However, the EZ will have to agree to (strictly) stick to revised budget deficits and to structural (including labour) reforms. I don’t believe that Germany will agree to Euro Bonds, a deposit guarantee scheme and/or a bond redemption fund at present. As a result, the ESM will have to be expanded in terms of available firepower, which in my view is granting it a banking licence. There are issues re Germany’s constitution, but I believe that German politicians have breached constitutional issues (and know it) before and will be prepared to do it again. The good news is that we are fast coming to crunch time. The EZ only moves in a crisis and boy do we have one at present. Mr Soros believes that the EZ has 3 months, I believe closer to 1 month. Yes, everything could go pear shaped – however, it is my view that it will not and, indeed, the current (fast worsening situation) will force EZ politicians to act.

Greece has an amazing ability to disappoint, so caution is certainly warranted. However, I believe that the good news is that some kind of fix is necessary (and will be implemented) in the very near future – delayed if New Democracy wins.

I realise that most are highly sceptical/bearish, but personally I’m not. Sure volatility is going to rise, but with institutional liquidity levels high and investors uber cautious (short or at least cashed up to exceedingly high levels), the possibility of a major rebound (65% to 70%+ chance), as opposed to a collapse, remains.

European markets are off today, but by only around -0.3% to -0.6% – the German DAX is the worst performer of the European majors, though both Spain and Greece are higher – interesting, don’t you think. In addition, financials are not performing too badly.

US markets have opened higher. The Euro is close to its highs for the day – currently around US$1.26. Does not seem like panic out there.

The markets have been subject to bad and yet more bad news from the EZ. Any good news (Syriza losing) should be pretty positive, though I accept will fade rapidly if not followed up with the necessary policy measures.

Finally, the likelihood of coordinated Central Bank action (in the event of a crisis), or at the very least, policy action by the FED, ECB, BoE, (and others) must be a distinct possibility, if there is really bad news.

Kiron Sarkar

14th June 2012

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