The Euro

Somewhat off topic from my usual Canadian fair, today I’m having a brief look at the survivability of the Euro.

On the Pro side:

·        Euro has cut transaction costs

·        Helped European integration

On the Con side:

·        Imperfect union has made it easy for irresponsible behavior

·        Increased systemic risk

There are many other aspects to the Euro, but for Germany and France (the main sponsors) the reality is that the Euro has created an easy to access market for their exports.  In fact, the vast majority of trade occurs within Europe, with China and Canada being two notable exceptions.  The argument for the Euro is strong, and in fact the weakness are really not that serious – Canada has a very similar make-up, with each province able to borrow in its own rights, although taxes are paid at both level of government (Federal and Provincial) for most Canadian this is only one tax document (notable exception is Quebec).  Each province borrows in the international capital market and is responsible for its own credit rating.  Quebec is a good example where the risk of downgrading forced the then government to undertake massive service cuts – something in the order of 10%.

Therefore, closer fiscal integration would help, but is not considered essential to the survival of the Euro.

So the reality of Greece and Ireland (Portugal, Spain and Italy too) is not so different than Canada!  What is different is that there was a perception (which turned out to be partially true) that the European central bank would stand behind the credit of each state, and therefore Greece and Portugal were able to borrow far in excess of what Quebec was able to do in the mid 90s.  Once again the rating agencies failed in their work!  Do we need more proof that these guys are a menace?

There is ample evidence that many were guilty for allowing the PIIGS to continue on their wayward ways, there was an implicit guarantee from the ECB

Proof, if any was needed, that the European banking elite has found an attractive solution to the problem of holding in excess of €200 billion in Greek sovereign debt; they “sold” it to the European Central bank at par, because the deal in place is that all Greek debt issued before 2013 will be fully guaranteed – there will be no write-offs (no once seems interested in the idea that no one in their right mind will acquire 2013 Greek debt).  So over the past 18 months European banks have reduced their Greek bond holding from €200 billion to something less than €140 billion (ECB has indicated that it has taken on nearly €60 billion in Greek debt, most of that would be roll over of secondary market acquisitions from the European banks).  Once again, the losses have been taken from the private sector and have been socialized – Europe four largest banks (BNP, SocGen, Commerzbank, and Deutsch Bank) total market capitalization is €114 billion.  Assuming a 30% hair cut on the Greek debt (the “agreed” amount from various punters – from the Economist to the FT) the total reduction in Europe’s four largest banks would have been 50%.  

Because European banks are for more leveraged than their North American counterparts, and that a substantial portion of their classified as “low risk assets” are sovereign exposure to the PIIGS.  They are too big to fail and will/have received support from the authorities.

The survivability of the Euro remains in doubt not because further integration is necessary for the survival of that currency.  Rather, will the various PIIGS to take the necessary steps in resolving the issues at hand e.g.  Excessive outstanding debt.  It is important to note that until two years ago Spain and Ireland were not seen as basket cases because their sovereign debt levels were low, but there was recognition (even then) that their lightly regulated banking market (all Irish banks, and the Cajas in Spain) could cause some serious problem to their respective governments.

Part of the dilemma today is that the sharing of the pain appears unequal (not ready to say whether it is unequal).  Greece’s growing black-market economy (not that it was small before) is certain to grow even more, while the level of unemployment and underemployment is certain to cause social strife.  Already the new Irish government has talked down the risk of write-offs, if they can get better terms out of the ECB.  However, the pain of restructuring has only just begun the next few months will be telling.  The recent explosion in food and fuel prices may accelerate the popular outcry.  

The real issue now, is that little of the fundamental problems of Greece and the other PIGS have been addressed.  Greece’s total debt is now at 120% of GDP, up from 104% a year ago.  That doesn’t look like a solution to me!

The PIIGS are in the same situation as the U.S. Federal government’s deficit.  Everyone knows there’s a massive problem there, but no one has any idea (or courage) to address the problem.  Whether its cutting U.S. Federal entitlement programs (the third rail of politics in the U.S) or addressing the unsustainable level of debt by the PIIGS (especially if interest rates start to rise in Europe – as the ZIRP interest rate policy is now starting to seriously damage OECD economies).