Will the market force Germany into making a decision?

November 24th, 2011

In yesterday’s post, I explained why it would be difficult for Germany to support any euro rescue effort that transfers risk from the peripheral nations to itself. Eurobonds are one such solution. And while eurobonds allow the peripheral nations to access cheaper funds, they will increase financing cost for Germany and France. Till yesterday, Germany was unwilling to commit itself to a position on Eurobonds. Today, the markets signalled that Germany needs to decide.

Germany was able to sell just over 60% of a scheduled government bond issue of €6 billion at an average yield of 1.98%. Secondary market yields on German sovereign debt rose in the aftermath of this issue to 2.09%. This reduced attraction to German sovereign debt could well be fuelled by the possibility that if Germany were to agree to the eurobond solution, it would borrow at higher rates as explained yesterday. While the credit quality of Eurobonds will be inferior to Germany’s due to contamination by other Euro nations, they would be treated in a similar manner for risk weight and other risk management purposes. In this scenario, buying German Bunds now would deprive market participants of additional yield that may be available in the coming days.

Logically, participants would wait for a German decision either way, resulting in reduced demand for existing and fresh German sovereign debt. Yesterday’s failed sale of German Bunds seems to suggest that this has come to pass. For Germany, this is a grim reminder that even though it believes the decision deserves serious deliberations and time, time is a luxury it may not have.

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The Euro - is there a way forward?

November 23rd, 2011

The Eurozone’s travails have been occupying centre stage for virtually all markets around the world for some time now. Despite the passage of time, involvement of some of the best financial brains in the world and apparent willingness on the part of Germany & France, a solution seems to be not only elusive but increasingly impossible from a realistic standpoint. As data about the finances of countries that comprise the core of the Eurozone emerge, reasons for the impossible problem facing the Eurozone become apparent.

However, the most important factor that one needs to bear in mind when analysing these, is the status of all countries in the currency union. While all these countries seem to have a currency that they can call a ‘domestic currency’, it differs from normal domestic currency in one critical aspect.

None of the participant nations in the currency union can create their currency at will, like other counties with a domestic currency can. The US for example, can create any quantity of the US dollar that it wishes to, based solely on its domestic requirements, without any restrictions from other countries. Japan can do the same, as can India and all other countries that have their own domestic currency. In the Eurozone, countries can create fresh Euros through the ECB, which can either agree or disagree based on its judgement of the requirements of the Eurozone as a whole. Therefore, factors other than the nations own economy influence this decision meaningfully, robbing these countries of the freedom others enjoy. And it is this freedom, the ability to create money at will, that distinguishes sovereign debt from all others. Put simply, while all other borrowers have to earn the money required to repay their debts, a sovereign nation borrowing in its own currency (which is completely in its control) can, in the absence of earnings, simply create the money required to repay its debts. Participants in the Eurozone do not have this ability. As a consequence, their ability to repay debt is completely dependent on their ability to earn the money required.

It is in this context, that the finances of each nation participating in the Euro become critical. Ignoring Greece for the moment, since it is already in technical default and funded by the ECB and the EFSF, it is equally instructive to analyse the others.

Italy, with a Debt/GDP ratio of 120.5%, has a primary surplus of 3.1% of GDP. This implies that if its average cost of borrowing exceeds 2.57% p.a., its primary surplus will be insufficient to cover interest cost. This would force it to borrow to pay interest which would result in a fiscal deficit and in the absence of economic growth, an increased Debt/GDP ratio. With an existing average cost of just over 4.1% and a fiscal deficit of 4.6% of GDP in 2010, it was agreed that Italy would embark on an austerity program that would allow it to achieve fiscal balance by 2014. This was before recent events that sent market yields on Italian government debt soaring to their Euro era highs of 7%.

With 26% of outstanding Italian debt due for maturity in 2012 which will need to be refinanced at an interest rate 3% higher than the existing average, a lot more austerity will be required to achieve fiscal balance and stabilise the Debt/GDP ratio. When seen along with the possibility that such austerity may cause the economy to shrink, it seems increasingly unlikely that Italy would find its way out of the woods in the near future.

Spain, with a Debt/GDP ratio of 72% of GDP may seem to be in a better position. However, it already has a primary deficit of 3.5% of GDP at a time when it needs a surplus of 2.5% of GDP to stabilise its Debt/GDP ratio (at the existing average cost of borrowing of 3.5%). Also, market yields on Spanish debt have also risen to near 7% levels, which would result in higher refinancing costs for the 16% of its total debt maturing in the next year. To make matters worse, its existing economic condition does not allow any serious consideration of austerity measures; unemployment is at 21.5% with Spanish GDP growing at less than 1% over the last year and widely expected to shrink in the current year. In summary, Spain’s troubles seem unlikely to fade as well, although for entirely different reasons.

Similar conclusions can be drawn for Portugal and Ireland, though the latter seems to be best placed to weather the storm. The common thread in all these cases is the increased possibility that these countries may not be able to finance their needs independently, and if they are, the cost of this financing would do more damage than good. Consequently, the most popular solution among market participants at the moment seems to be the Eurobond solution. In this proposed solution, all national sovereign bonds in the Eurozone may be replaced with generic Eurobonds. Since these Eurobonds will be backed by the combined financial strength of all Eurozone countries, their credit quality will be better than that of the individual countries mentioned above and lenders would be more willing to buy these at yields significantly lower than those existing for these countries.

However, on the flip side, the credit quality of the combined entity would be worse than the individual credit quality of both France and Germany. As a result, both would need to borrow at interest rates higher than they do at the moment. An indication of the rate at which funds would be available to this combined entity is available in the market yields of bonds issued by the European Financial Stability Fund (EFSF) which was established to fund bailouts of these periphery nations and is backed by the financial might by all nations of the Eurozone. EFSF bonds currently trade at 200 bps, or 2% above German Bunds. This is where the solution starts unravelling.

Germany’s current Debt/GDP ratio is just over 81% of GDP and it generates a primary surplus of 1.3%, which covers an average interest cost of 1.6% p.a. Its current cost of borrowing is in the region of 1.8% p.a. which when seen together with GDP growth of 3.6% in 2010 and expected GDP growth of about 2% in 2011, will allow it to progressively reduce its Debt/GDP ratio every year. Any increase in borrowing cost would hamper this reduction and will be extremely tricky to position politically.

After all, in the German mind, they have done everything as it should be done and are being rewarded by the markets with low interest rates on their borrowings. Accepting a cost of funds that is more than double their existing cost along with the possibility of greater debt burden, to assist nations which have been unreasonably profligate in their ways is sure to offend the austerity loving German gravely. This is especially true when there is no sign of the peripheral nations making any serious attempts to address the root causes of these issues. While almost every elected official has paid lip service to this goal, when confronted with the task of implementing decisions that would achieve it, responsibility has been entrusted to non-elected governments in two of the most severely afflicted countries. And while there is hope that these technocrat-heavy governments will be able to implement unpopular decisions, this hope may well be dashed at the altar of populism when the time comes.

This sentiment was reflected in the German Chancellor, Angela Merkel’s statements yesterday. While stopping short of an outright rejection of the Eurobond solution, Ms. Merkel made it clear that in the current environment, it is extremely difficult to imagine German support for it. It seems increasingly clear that Germany would consider it only if fiscal decision making in these countries was moved from local politicians to a central European body, where Germany would have the required influence to ensure fiscal discipline. This is, at best, a long drawn process involving political negotiations and treaty renegotiations.

In the absence of any short term solutions, it seems extremely likely that the Eurozone crisis will continue to haunt markets. Unfortunately, this is not one of those situations that find a cure in the passage of time. In fact, each passing week worsens the finances of the peripheral nations. Each passing week increases the probability that the Euro, in its current form, will soon cease to exist.

The blogger is an independent macro-economic consultant and has been a part of the debt market for over 15 years. He also blogs at www.rajivshastri.com. Views are personal

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