European Affairs

This week will be crucial in determining not only Greece’s future but that of the Euro zone. Unless the principal Greek parties reach a surprise compromise on a coalition government, there will be new elections on June 17. Voters, infuriated with a 20% decline in GDP and soaring unemployment (close to 50% for young people), are likely to reject again those parties willing to implement the tax increases and pay cuts agreed to in February in return for a second € 170 billion ($218 billion - calculated at this morning’s market rate of $1.287 per €) bailout. On May 6, voters gave the New Democracy and PASOK socialist parties only 32% of the vote, compared with an average 80% since 1974. The new election would certainly lead to a government that would reject more austerity and try to roll back current measures.

The “troika” of Greek creditors: the European Commission (EC), the European Central Bank (ECB) and the IMF would then have to renegotiate the bailout agreement in time for Greece to meet major debt servicing due in September, or refuse any change in the February agreement. If the new government then defaulted on servicing its loans from the EC, ECB and IMF, Greece would lose all access to international credit with which to buy food and oil; and its banking system would collapse. Unless Euro zone governments and the ECB relented on austerity, Greece would effectively be forced out of the euro, even though 70% of Greeks say they wish to remain in the Euro zone.



Before this happens, however, there are many other moving parts to the Euro end game. Most important may be a meeting (15 May) between France’s new Socialist President Francois Hollande, who, after being sworn in tomorrow morning and announcing his new Prime Minister and cabinet, will fly to Berlin to meet German Chancellor Angela Merkel.

The German-French leadership couple, “Merkollande”, (replacing the “Merkozy” duo of Merkel and former president Sarkozy) could initially be problematic since he was elected on promises to stimulate economic growth. She and her center-right coalition parties, on the other hand, have been punished in the last four major regional elections, including North Rhine – Westphalia (May 13) and Schleswig-Holstein on May 6 - for helping to bail out Greece and slowing economic growth in Germany. Today, the Merkel government faces electoral defeat in federal elections which must be held no later than Oct. 27, 2013.

Merkel must, nevertheless, negotiate a modus vivendi with Hollande, her most important European partner, despite angry German voters. There are signs, however, that Merkollande could agree on some measures to supplement the “fiscal compact” (formally, the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union), agreed on March 2, 2012 by 25 of the 27 EU countries (the UK and Czech Republic refused). It is to come into effect Jan. 1, 2013, if 12 Euro zone governments have ratified it. The compact is the most important step yet taken toward the fiscal (budgetary) union that is essential for the Euro’s long-term survival. Given, however, the irresistible political and market forces under way, it may be too little too late to save the euro. Merkel may thus agree with Hollande on some economic stimulus, but she will not back down on the 3% (of GDP) deficit and 60% (of GDP) debt medium-term targets which are the basis of the new treaty.


“Target 2” Imbalances and Contagion

Acutely aware that the Deutsche Bundesbank is publicly hostile to further bailouts of Greece, or other Euro zone “peripherals” in trouble, such as Spain, Portugal, Ireland or Italy; Merkel is unlikely to allow the ECB to finance, directly, those governments’ deficits. The ECB has, however, purchased Spanish and Italian government bonds on the secondary market, indirectly supporting these governments’ finances, but technically respecting its mandate not to finance government debt directly.

Hollande’s desire to issue Euro zone bonds, guaranteed by all 17 Euro governments, to finance infrastructural projects and stimulate economic growth, may also be a non-starter since fiscal hawks in Merkel’s government and the Bundesbank resist further German exposure to the peripherals. Under “TARGET 2” accounting procedures for the European System of Central Banks, the Bundesbank is one of only four Euro creditor countries in March, and is owed €644 billion ($830 billion) by the ECB. (TARGET is Trans-European Automated Real-time Gross settlement Express Transfer

system: the Eurosystem’s real-time gross settlement system for the euro.) The Ifo research institute reported that Germany’s TARGET 2 credit balance rose an average €33 billion ($42 billion) a month since July 2011 when the Euro crisis worsened sharply. Italy and Spain had a combined TARGET 2 debt to the ECB of € 555 billion ($915 billion) in March.

The TARGET 2 imbalances would explode from their already high level if Greece defaults and/or quits the Euro system; and because of the impact on the peripherals. This “contagion effect” is clearly illustrated by the changing difference in Euro government borrowing costs, measured as the spread between the yield on the ten-year German government bond (“bund”) and the rate paid by other governments. While the bund yield has plunged from 3.5% a year ago (May 2011) to 1.5% today (as investors bought safe bunds), Greece’s spread over the bund yield soared to 33% in December, then declined to around 18% with the February bailout. Since the Greek election, it is back up to 25%. Such exorbitantly high rates mean, of course, that Greece is effectively cut off from international borrowing.

If Greece defaults and exits the Euro system, a “Grexit” to which Citigroup last week assigned a 50%-to-75% probability, markets would focus on the other Euro countries deemed most likely to require a bailout. Spain is the top candidate with a non-financial private sector debt load estimated by McKinsey at 134% of GDP. (Government debt amounts to only 70% of GDP, compared with 165% for Greece and 120% for Italy.) Spain’s total government, household and bank debt amounts, McKinsey calculated, to 363% of GDP, compared with 512% in Japan and the U.K. at 507%.


Euro Banks Vulnerable

The Spanish banking system’s exposure to the imploding mortgage debt bubble forced the government to rescue Bankia, the third largest bank, last week; and to oblige all banks to reserve 30% for the bad property loans estimated to total € 310 billion ($ 400 billion). Last year, the government had to rescue regional savings banks. But Spain’s double-dip recession and 25% unemployment, exacerbated by draconian austerity measures, make this banking crisis far more problematical. As a result, Spanish banks are considered among the most illiquid in the Euro zone. And the government must pay 6.2% today to borrow ten-year money, up from just 4% a year ago.

Spain’s bank problems are symptomatic of what may be the most immediate threat from a Greek default: the vulnerability of Euro zone banks, which in turn threatens the wider European and international banking system. An example is France’s Credit Agricole which is reported ready to reserve nearly € 1 billion ($1.28 billion) against its exposure to a Greek bank bought in 2006.

International ramifications are also dangerous. The surprise $ 2 billion hedging loss reported last week by JPMorgan Chase was perhaps related to volatility in key derivative indices caused by market worries about Greece’s impact on Euro zone banks – a reminder of how inter-connected major banks are. Last winter’s Greek crisis caused a liquidity crunch for Euro zone banks so severe that the ECB offered three-year, virtually no-cost funds to Euro banks with its Longer-Term Refinancing Operations (LTRO) facility last December and in February 2012. Revealingly, more than 800 banks took up a gross total of over € 1 trillion ($1.28 trillion) in the two LTROs.

While credited with insuring Euro banking liquidity, the ECB’s quantitative easing has proved a mixed blessing because numerous banks used the cheap funding to buy their governments’ bonds, thereby easing pressure on those governments to enact much needed budgetary discipline; and not boosting the banks’ core capital ratios. Moreover, Greece’s new and far more serious political crisis is causing renewed stresses in Euro zone banking even though markets assume the ECB would again assure liquidity to keep the banks open – a “moral hazard” for the central bank that is likely to worsen.


Grexit worries weaken euro

All these negatives are, at last, weighing on the euro’s exchange rate. Since the Euro crisis began in late 2009, the euro averaged $1.358, hitting a high of $1.487 just a year ago (May 3, 2011). Current worries about a “Grexit” have, however, caused the euro to lose 6% against the dollar in the last ten days, down to $1.287 today. The euro is also down about 6% against sterling and even more against the yen. Technical analysis suggests that the euro could weaken toward $1.20 or less if the Greek crisis remains unresolved by mid-summer.

Euro depreciation is, however, a welcome dividend from the crisis since the single currency had been over-valued, especially against the dollar, and depressed Euro zone exports. A weaker euro will stimulate exports and contribute to economic growth, although flagging economic conditions in the U.S., China and Latin America could limit their import demand for euro-priced products.


Austerity or Stimulus ?

Improving export growth will be one of the few bright spots facing Angela Merkel and Francois Hollande tomorrow (Tuesday, May 15). Their principal concern will be to fix the vicious cycle of austerity aggravated by economic recession which causes markets to boost borrowing costs which exacerbates the overall situation. France’s new president wants powerful and immediate stimulus, including German measures to boost domestic demand, a move politically-weakened Merkel might appreciate. He also supports an E.U. financial transaction tax, which would be used, together with E.U. structural funds, for infrastructural projects to stimulate the economy. But German and British (and U.S.) financial institutions reject any such tax on financial transactions. Hollande would also like to ease the ECB’s mandate to limit Euro zone inflation to 2% or less, a move the Bundesbank and the ECB will reject.

Current Euro zone economic indicators point to a possible small recession in the second and third quarter, especially if the Greek crisis goes critical after the June election and international growth weakens. With the Euro zone unemployment rate at 10.9% (equivalent to 17.3 million people), a more vigorous approach to stimulating economic growth seems imperative if political rejection of budgetary reforms is to be countered and social unrest is to be prevented. We expect Merkollande to approve new stimulus.


More Euro Cooperation Ahead ?

Not surprisingly, the Greek, and related crises, have galvanized Euro politicians and the ECB into taking measures they would never have taken otherwise. The ECB’s purchases of government bonds and LTROs proved to be very timely and saved the Euro banking system, at least temporarily. Euro leaders also agreed to create the European Stability Mechanism (ESM), a permanent rescue funding program which will succeed the AAA-rated but temporary European Financial Stability Facility (EFSF), which has lending authority up to € 440 billion ($566 billion); and the  European Financial Stabilization Mechanism (EFSM) in the Euro zone. The ESM is due to be launched when Euro member states representing 90% of the capital commitments have ratified it, perhaps this summer.

Given the drastically restructured political reality triggered by the Greek crisis and massive voter rejection of excessive austerity (eight Euro governments have changed since the crisis began), we expect new measures to be agreed as the current Greek crisis focuses politicians’ attention on the financial-economic disaster that will occur if they do nothing. The most important must be to double or triple the ESM’s borrowing and lending capacity from approximately € 1 trillion ($1.28 trillion), to convince markets that it is an effective firewall against a Spanish or Italian crisis following a Grexit.

The fiscal compact must be revised to take into account the negative budgetary impacts of cyclical factors such as recession and financial credit crunches and make the deficit and debt ratios medium term targets. Euro zone leaders must also force their banks to restructure by provisioning toxic assets, and to submit to cross-Euro zone regulation and supervision to prevent systemic risk phenomenon of TBTF (Too Big To Fail) banks that makes the U.S. banking system so vulnerable. Euro leaders, notably the Germans and Dutch, should also approve the concept of Euro bonds which would represent a weighted collective responsibility of the 17 Euro governments, a mechanism that would enormously increase Euro borrowing power.

Finally, the ECB must be allowed to do whatever is necessary to preserve the Euro zone banking system, including keeping Greek banks afloat; purchasing the peripherals’ government bonds on the secondary market to smooth market interest rate spikes; to supervise individual banks, and, if necessary, to split up TBTF banks to prevent systemic risk.


Grexit ?

Will Greece exit the Euro, as Citigroup so confidently forecasts? We think Greece will have new elections which will confirm voter antipathy to yet more austerity. But as a result of Merkollande agreeing to a modus vivendi between a more relaxed fiscal compact and new measures to stimulate growth, plus measures to enhance euro firewalls, we think the new Greek government will win enough relief for that country to remain in the Euro system.

Markets, having seen Merkollande cooperate and move forward on more Euro zone restructuring, will be pacified. And the euro will struggle on.


J. Paul Horne is an Independent International Market Economist based in Alexandria, VA and Paris where he was chief international economist for Smith Barney for 24 years. He retired as a Managing Director of Salomon Smith Barney/Citigroup in 2001.