Stress in the Eurozone – A Follow-Up

Stress in the Eurozone – A Follow-Up
July 26, 2011

This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist. He joined Cumberland after years of experience at the OECD in Paris. His bio is found on Cumberland’s home page, He can be reached at

As global investors’ attention moves back across the Atlantic to the US debt-ceiling/budget-deficit drama, the Eurozone crisis has eased. However, as discussed below, we still have not seen the final act. Last week, at their summit, the Eurozone leaders finally took some important steps designed to deal with the sovereign debt crisis. The text of the July 21 “Statement by the Heads of State or Government of the Euro Area and EU Institutions” can be found here. While the agreed actions cannot be described as a comprehensive solution to the multiple issues that brought about this crisis, they indicate that governments understand and are now ready to effectively address most of them. This result exceeded by a considerable margin the expectations of many, and the actions were positively received by European equity markets. The subsequent rally in these markets extended for four days, only to be cut short by unease over the political impasse in the US.

The most immediate need facing Europe’s leaders, Greece’s financing gap, was met with an agreement to provide 109 billion euros ($159 billion) in official financing for Greece. This includes traditional direct-rescue funding loans, a provision of 20 billion euros for buybacks of Greek government bonds, and several programs that are designed to encourage private bond holders to participate in the rescue, swapping old bonds for new ones with longer maturities and enhanced credit. Bond holders that participate will experience an estimated loss of 21% in current value. To offset this damage to bank bond holders, 20 billion euros is being provided for bank recapitalization. As some have noted, the decision to allow the European Financial Stability Facility (EFSF) to recapitalize banks could well have long-run fiscal implications.

Another important element relates to the terms of the existing European Union/IMF programs for Ireland, Portugal, and Greece. Maturities have been extended and interest rates lowered, a step that will provide an important easing of the financial burdens facing these countries.

An increase in the role and flexibility of the EFSF to address contagion is particularly welcome. In future the EFSF will be able to act pre-emptively “to avoid contagion” on behalf of any Eurozone country, including countries not already in a rescue program, by intervening in secondary markets. This action would be based on analysis by the European Central Bank (ECB) that indicates “the existence of exceptional financial market circumstances and risks to financial stability.” As noted above, the EFSF also is to be allowed to “recapitalize financial institutions through loans to governments.” This provision also extends to all Eurozone member countries. A notable omission in these decisions is any increase in the size of the EFSF. An increase surely will be needed and hopefully will be made before another crisis arises and forces governments to act.

The move to finally recognize the need to have some restructuring of Greece’s debt had become unavoidable, and the leaders’ decision to bite the bullet on this was welcome. Moody’s subsequent downgrade of Greek debt this week was expected by markets. However, Moody’s warning about possible future downgrades of creditor countries because of the implications of last week’s decisions is troubling markets as we write.

At Cumberland Advisors, we believe the immediate crisis in the Eurozone has been eased and the members’ weapons to counter future flare-ups have been strengthened. Resolution of the crisis can come about only through increased competivity, investment and growth, which will require politically difficult economic reforms, particularly in the weaker-economy countries. Bearing in mind the restrictive fiscal policies that are required, these economies face an extended period of suboptimal growth. The performance of the stronger Eurozone core economies, in particular Germany and France, will likely continue to diverge from that of the weaker economies. We have raised our heavy underweight of the Eurozone in our International and Global Multi-Asset Class portfolios back to light underweight positions. We are refraining from going to overweight because of our concerns about the Eurozone banks, the headwinds of restrictive fiscal policies, and the possibility of further monetary tightening by the ECB.

Bill Witherell, Chief Global Economist

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