The Euro – Anticipating the End Game
by Patrick Butler, Board Member, Raiffeisen Bank International
In the 1990s treasurers made a fortune from the ‘convergence trade’. Back then, future member countries were preparing for the introduction of the euro, diligently working towards fulfilment of the Maastricht criteria. These required a total government deficit to GDP of no more than 60%, an annual deficit no higher than 3%, and long-term interest rates no higher than 2% above the three lowest inflation member states. (Halcyon days!) Against this background, the assumption was that interest rates in those countries where inflation had traditionally been much higher than Germany’s would move down to match DM levels. That assumption proved justified and funding Italian government bonds, for instance, in DM, generated substantial carry profits, a capital gain and no counterbalancing currency loss.
During the past year, conversely, the smart money has been on the divergence trade, betting, essentially, on an increase in yields in the peripheral euro-countries relative to the hard core, in particular Germany. And that divergence has been dramatic. Greek Government five-year credit default swaps (CDS), for instance, started 2010 around 2.55% above Germany’s, and are ending it around 9% over. Despite, however, all the political noise and blame directed at speculators and wicked bankers, this phenomenon is caused not primarily by market participants actively shorting risk, but by a simple excess of supply over demand: a glut of debt-issuance by high deficit governments and an absence of investors. So extreme has this disconnect become that two member countries have already had to turn to the IMF and EU for financial support – a bail-out – and they may not be the last. Every day, politicians, media and market pundits prognosticate on developments, propose solutions and predict the next twist. The treasurer, though, needs to understand the drivers and dynamics so that he can prepare and, where possible, position for potential outcomes. Although the future could take one of a number of paths, that number is, in reality, very limited, as a brief analysis of how we got here demonstrates.
In the run-up to monetary union much attention – correctly – was paid to ensuring that countries joined at the ‘right rates’; that their relative exchange-rate related competitiveness at the time was, as near as possible, equivalent. This was necessary to avoid the shock, and adverse consequences, not just on the affected country, but on the rest of the bloc, of an effective revaluation or devaluation on the part of any one state. Similarly, economic and monetary convergence were emphasised. As Wim Duisenberg put it in 1997: “… exchange rate stability can be achieved only in the presence of continued convergence of economic fundamentals – in particular price stability – and sound fiscal and structural policies”. Indeed, this was the raison d’etre for the Maastricht criteria, and a laudable, essential prerequisite for the common currency.
A two-tier, or rather, multi-tier Eurozone has developed, light-years away from the economic convergence envisaged and required.
In the euphoria – and, in retrospect – complacency following the euro’s successful introduction, the reality that economic convergence was a sine qua non for the continued stability and success of the euro-bloc received far less attention than it deserved. Those were heady times. A decade after the fall of the Berlin Wall, it appeared to some that the liberal, (relatively) free-market principles of post World War II Western Europe could be enshrined in an economic and financial union which might gradually expand to encompass most, if not all, of the continent. Potential member countries were queuing up to gain admission, firstly to the EU, then to the monetary union. The ‘great moderation’, relatively loose monetary policies and a gradual, insidious but massive increase in private sector leverage bolstered a confidence which was not justified by the fundamentals..
Convergence, the process by which the economic cycle, and, in particular, relative competitiveness merged, went into reverse, though this reality was masked by debt-fuelled growth in the peripheral countries. Indeed, conventional wisdom at the time was that the euro had helped unleash the potential of Spain, Portugal, Italy, Ireland and Greece, while core Europe would be condemned to the slow track until the rest caught up. We can now see – as figure 1 clearly demonstrates – that the fringe countries were living on borrowed time and money, leading to a sharp decline in competitiveness and chronic balance of payments deficits, financed by public and private sector borrowing.