- Sovereign debt concerns continue to weigh on global equity markets and few expect much help from this week’s EU summit as the 16-nation euro zone is divided over whether or how to aid Greece.
- Heavy debt burdens later this year should test the finances of several European countries and will likely place upward pressure on European interest rates and default spreads.
- Some believe that absent severe (and difficult politically) austerity measures there is a risk of a breakdown of the European Monetary Union (EMU).
Background
The budgetary constitution of the EMU explicitly imposes limits to both public debt (60 percent) and budget deficit (3 percent) ratios. Thus the existence of European Monetary Union as well as the Euro is constitutionally anchored on public finance requirements that are now in the process of being breached. The European Commission (EC) recently estimated that the 2011 public debt as a percentage of GDP could hit 135.4 percent for Greece, 117.8 percent for Italy, 96.2 percent for Ireland, and 79.7 percent for Germany. Likewise, the EC is projecting that virtually all of the major European countries will exceed the 3 percent budget deficit limit in both 2010 and 2011, with Greece, Ireland, and Spain likely to have budget shortfalls north of 9 percent if more aggressive austerity measures are not implemented. This, combined with the recent financing challenges in Greece, has raised fears about a potential breakdown of the EMU.
What are the Options?
Withdrawing from the Euro…not a realistic option—The EU does not have a mechanism for a country to withdraw from EMU. Moreover, it is unlikely that the IMF will step in to help an EU country unless the EU is part of a workout process. If a country other than Germany left the Euro system and established a new currency it would likely see a sharp devaluation in its new currency, and significantly higher issuance costs which would make it even more difficult to pay back its debt. Leaving the Euro could spark a legal challenge to evaluate if the debt can be revalued into a new currency or to assess if this represents a technical default to either the debt or credit default swaps. In either case, this action would likely destroy wealth and savings, compromise the country’s banking system, increase defaults, and fuel political turmoil.
Sanction and Bailout Solution—The ultimate sanction for a country that fails to comply with the conditions of a support package is the loss of fiscal sovereignty. Aid from an EU supranational institution, e.g. the European Bank for Reconstruction and Development (EBRD) or the European Investment Bank (EIB) could be a problem legally as these entities can lend to projects not governments. Another option would be for the troubled country to receive either direct loans or a revolving loan facility from either a group of private institutions (e.g. European banks) or from other European member states. This could include some form of a bridge loan that is secured by tax revenues such as an increase in the VAT rate.
A German Bailout—Given that Germany is often viewed as the lender of last resort in Europe, one possibility is for Germany to be the driving force to provide short term funding (likely with other nations) to address the upcoming debt rollover and budget challenges for several of the weaker European countries. This highly unpopular measure could be part of a solution that is coordinated with an increase in the VAT, a reduction in government spending, and IMF support. However, if Germany or German institutions were to orchestrate such action, it would likely require implementation of even greater austerity measures by the weaker country which could further challenge the ability of the entity to grow its way out of the debt crisis. Alternatively, the Euro system could implement a tax in all countries in the EU to support the Euro and provide the source of capital when emergency funding is needed. The EU could set this tax on a floating scale to lower the cost for those countries that are more fiscally responsible, which, in turn, would place greater pressure on those economies that are struggling.
The Nuclear Option—The European countries could try to reverse the Maastricht Treaty by holding coordinated public votes to end the EMU and create a conversion rate for each country to reestablish its own currency. This would likely create chaos, challenge bankruptcy laws, weaken European FOREX values, destroy savings, and hurt economic activity in both Europe and around the world. Moreover, it would be extremely difficult for such action to take place in a timely process.
The Most Likely Scenario
Germany is expected to take the dominant role in the bailout debt restructuring process within the EMU, with Bundesbank President Axel Weber targeted as a future leader of the ECB for 2011. Despite public protests, ECB leaders are likely to strengthen the procedures for applying the Stability and Growth Pact (SGP), which sets limits on government’s deficit and debt levels. This will be especially challenging for Greece, Portugal, and Spain. The ECB will probably be unable to establish a monetary fund that could be tapped to avert future crises.
Immediately ahead, Greece is likely to get funding from the EU/EMU countries (and possibly even the IMF) with the IMF providing technical assistance and operating as lending backstop. Greece will be forced to implement new austerity measures such as VAT increases and major cuts in government outlays including employment, wages, retirement, and health care benefits. Although a relief rally might unfold for the Euro as the “nuclear option” of an individual country default is averted, the significant fiscal policy restraints, combined with negative demographic conditions and the still high cost structure in Europe, are likely to place handcuffs on European economic activity for several years.
What are the Implications for Investors?
The evolving sovereign debt crisis is an immediate challenge for Greece and the EU, and, longer term it has broad global implications for investors. Heavy maturing debt burdens later this year should test the finances of several European countries and will likely place upward pressure on European interest rates and default spreads. Forced fiscal policy cutbacks may keep southern Europe in a recession for the bulk of this year. Overall European economic activity will be challenged to expand at more than one percent in 2010 and two percent in 2011. The softer relative economic activity in Europe versus the rest of the world will likely present a negative risk for tax revenues and budget conditions that could keep deficit ratios at a higher-than-desired six to 10+ percent range for several European countries. This could increase fears that the EU will need to “inflate its way out” of these problems, placing additional downward pressure on the Euro and upward pressure on European intermediate and long term interest rates.
The market consequences of such an event would likely hurt corporate profits, depress PE ratios, weaken the European equity market, and fuel a “flight to quality” rally into the U.S. dollar, Japanese yen, and/or commodity currencies. Moreover, a contagion could unfold that would challenge eastern European emerging markets and economies, as well as eventually dampen economic conditions, increase inflation risks, and sharply raise the term structure of interest rates around the world. The hardship could also impact those countries with the largest external financing needs, possibly including the U.S. and, even more so, the U.K.
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