Published: February 01, 2011
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.[[[PAGE]]]
Though the causes of the financial crisis – which was unfolding from 2006 onwards and reached its high (or low!) point on 15 Sept 2008 with the collapse of Lehman Brothers – are many, over-exorbitant borrowing to finance consumer expenditure was one of them. That binge is now over, and the Eurozone must cope with the hangover.
A two-speed, or rather, multi-speed Eurozone has developed, light-years away from the economic convergence envisaged and required. The first task for countries such as Greece, Ireland and Portugal is to reduce public and (in the case of Ireland and Portugal) also private borrowing. This is theoretically achievable through one, or a combination of means.
What is more, in the current political atmosphere in core Europe, where ruling parties cannot justify to their tax-payers bankrolling a country which doctored its numbers to enter the euro in the first place, and where voters are angry that the promise of ‘no-bail outs’ (laid down in Germany by the Constitutional Court) has not been kept, cross-border subsidies to reduce the overall debt can probably be ruled out. That leaves restructuring, which in the case of Greece (and possibly others, depending on economic development) appears now the most probable option. It is often objected that the ECB cannot allow this, as it holds so much Greek paper. But one part is held as collateral against lending operations; this is subjected to a substantial discount, anyway, and – assuming the counterparty remains solvent – must be repurchased when the borrowing expires. The rest has been purchased at distressed levels; debt forgiveness, therefore, may not impose a haircut on these holdings significantly below the purchase price. And, if it does; the loss to the Eurozone tax-payer is far less visible than it would be through a simple multi-billion transfer, making it, perhaps, more politically palatable.
Aside from private investors, the other big institutional holders of Greek bonds are European banks and, of course, Greek domestic banks. The former should have learned their lessons and reduced their exposures to the extent that a write-down can be absorbed without challenging capital adequacy. The latter will probably have to be recapitalised – something which the Greek government supported by IMF and EU would certainly be in a position to achieve, having just written off a significant portion of its liabilities.[[[PAGE]]]
The mechanism by which the restructuring is achieved may well, in any case, contain a ‘Brady’ element, enabling the banks not to write down any or all of their holding, but stretching out principal repayments and reducing interest to below commercial levels. Whatever model is used, the treasurer is well-advised to avoid exposure to the inevitable economic cost.
Until the markets sense progress in achieving true convergence, the euro will remain under pressure.
Whereas in Greece the sheer size of the deficit and the burden of debt-servicing make a restructuring in some form all but inevitable, the jury is out on Spain and Portugal. Much depends on future economic growth, the bottoming-out of assets, in particular, real estate prices, and investor willingness to give the benefit of the doubt, a willingness which in the past three years has diminished dramatically. Ireland is another case altogether, where the large public debt burden results from a bank rescue to which, as yet, only shareholders and subordinated debt holders have been required (or in the case of the latter, requested – with menaces) to contribute. Whether the political equation, and the sheer scale of the task, permit senior debt investors, at the very least in Anglo Irish, to remain whole is open to question. True, the Irish government has repeatedly ruled out introducing legislation to prefer depositors over senior creditors, thereby enabling haircuts on senior bond issues, but then again, until very recently, it also ruled out taking aid from the EU and the IMF.
Restructuring of sovereign and/or in specific cases bank debt is not the end game. The euro and its member states will only achieve long-term stability if there is genuine convergence – the creation of something approaching what the economists call an ‘ideal currency area’ or if lasting mechanisms are created to rectify disparities. As the graph demonstrates, during the first decade of the euro’s existence Greek wage costs have grown by roughly 27% more than German. This divergence – this loss of relative competitiveness – is simply unsustainable. Until the markets sense progress in achieving true convergence, the euro will remain under pressure. And sooner or later countries which cannot keep pace with core Europe in the current system will be forced to consider exit. That would not be possible without dislocation, complexity and cost. It would require support by the IMF and/or the EU to prevent meltdown of the departing country and its creditors. Today, it is inconceivable. But if the convergence problem is not resolved, the dislocation, complexity and costs of remaining in will be still greater. And as The Economist put it (4 December 2010) “Financial history is littered with events that turned from the unthinkable to the inevitable with breathtaking speed”. The past three years have demonstrated the truth in that assertion.
The opinions expressed in this article are those of the author alone.
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