Europe

A Mess Called Europe : Lots of Lehman-esque Lemons

Sanjeev

Sanjeev

Lebensraum: Germany has finally found it, although not quite the way they imagined it. Today, Europe is at its feet, except that maybe, Germany has no reason to want it there. Over the last year, we have all been focusing on the US. Much of the news has been about US equities, the effects the banks have had on stock markets, and the effects that mortgage markets have had on the banks. European banks were seen to be heavily exposed to the US, but that was it.

Declaimer: This article written was originally in August 2013, and some of the data points may be outdated.
The story shifts this year to a different canvas

But life is not yet finished with its twists and turns. The story shifts this year to a different canvas: one, it is no longer about the banks that threatened to go down the drain, but the countries that put out a hand to help. Two, the mayhem has shifted from the equity markets to the much larger currency markets. More important, if you were inactive in the Equity markets, you might have escaped the terror of last year; but there is no escaping the potential Armageddon if the currency markets deliver a contagion, such as we have never seen before.

If you look at the recent chart of the Euro, it looks remarkably like the Dow (or the Nifty) in Oct-Nov, 2008. Yet it is not such big news, at least here in India. Either we have grown inured to such things, or we do not realize its significance. For starters, this (the Euro) was the place where people were looking to flee. And as the cockroaches come out of the woodwork, we need to pause and think: in this headlong flight out of the Dollar, have we stopped to think just where we are going? I mean, the US has huge problems (no doubt), but it also has the most resilient economy in the world, besides the courage and culture that encourages ‘creative destruction’.

Take a look at just where people have been running to: they have bid up the Euro to 1.5 times the absolute value of the Dollar, simply because interest rates were held up by the ECB. And on average, the Eurozone has been contracting at 4%, with an average Budget deficit going from 6.9% to 7.5%, even as the average Govt is already 84% of GDP (even India is doing better). More important, the deficits will take Govt debt up another 22% of GDP, before they peak, leaving them paying 3.4% of their GDP as interest cost, or about 10% of their revenues.

The only solvent country: Germany contributes 20% of the Eurozone GDP, but its $2.8 trn GDP is made up of 45% exports (of which 47% is industrial machinery, 27% and auto exports, 19%). Its 4% Budget Deficit is also lesser than the average Eurozone deficit, and much lesser than the rest of the world. Given the nature of its price-inelastic exports, it will be the first country to rebound if global recovery picks up.

But look at the other countries: their GDP shrinking between 5-7%, Fiscal deficits exploding from 3-12%, Debt: GDP ratios all above 60-120%, and Interest already at 10% of Govt revenues. With no space to increase their total stock of debt relative to a shrinking GDP, their income is already stagnant to falling. Yet, the taking on of the debt burden of their recalcitrant (and truant) banks, is creating for these countries a bankruptcy trap. As these Govts step in to support their failing economies with stimulus plans or bailouts of their citizen banks, they are really funding holes in Balance Sheets. This has to be paid for by current savers, who are bridging the gap between today’s and the tax flows of future generations. These savers are no longer a kindly lot, especially after their recent experience with the US. They are demanding huge belt-tightening measures like the one mandating Greece to drop its Fiscal deficit below 8%, from the existing 12%

The normal bankruptcy ratio is a combination of these metrics.

The normal bankruptcy ratio is a combination of these metrics: the boundaries are set by Interest Rates, GDP growth rates, Fiscal deficits, Debt: GDP ratios, Tax: GDP ratios, and Interest: Govt revenue ratios. The last is really derived from the given set of numbers. The independent variables are really GDP growth rates, indebtedness, and tax ratios. At 20% of Govt revenues, Interest is in the red zone. This, combined with the Fiscal deficit, decides the debt trap. At one time, the Govt finds itself borrowing just to pay Interest. When this happens on an external account, the Govt is officially declared bankrupt.

Japan, India, and other Asian countries with high Savings rates have got into internal debt traps before, but if they have borrowed from their own people, they can always monetize away their liabilities. It does not get to be called bankruptcy. But Govts cannot print Forex, which is why they have to declare bankruptcy or resort to IMF protection (which is somewhat akin to Chapter 11 protection).

If Europe as a whole is mainly falling into this trap, the only country capable of any bailout is Germany. And with just 20% of European GDP, that is simply not large enough to make a difference. What is more, Germany has to decide whether it wants to remain part of a rag-tag set of countries that have already spent themselves into oblivion.

If Europe holds together, it will have to tighten its belts, something the minor countries are loathe to do. The pressure building up in Europe between those who save and those who borrow could tear apart the Eurozone itself. Germany has to decide whether Europe as an ideal is worth pursuing at the cost of its economic well-being. And if the free lunch ends, and it is time to pay back, the minor nations who came in looking for soft interest rates riding on the back of German (current account) surpluses and savings rates, will choose to go their way….if they can.

This is not a mess that will sort itself out any time soon, Nor is it linked to the sub-prime mess and the whatchamacallit that America is going through. This is an independent event, linked to the ‘unification’ of Europe, where different nations met at the high table called Europe, but for different objectives.

But certainly, this (situation in Europe) is hardly the kind of stuff that makes for a relative value of 1.5 times the value of the Dollar. It could be touch-and-go, as to who is in better shape, the US or Europe, with Japan a distinct third rank. Broadly, if I had to punt on direction rather than any fixed destination, I would rather sell both the JPY and the Euro against the Dollar. Not only do both these competing economies seem to be in worse shape than the US, it is well established that their intrinsic and structural ability to come back is decidedly inferior to that of the US. And if the currencies follow their respective economies, then that is where I rest my case.

All this does not augur well for the currency markets. If the ‘safe haven’ currency has proved to be such a disappointment, there seems to be nowhere to go. While this might make a case for the Gold bulls again, I am coming around to the view that Gold might prove to be a temporary safe haven, even while the world looks around for a well-managed country/ currency that proves itself worthy of its trust. Till then, Gold will be a temporary parking slot, but not a permanent one. So, it sounds complex, but it does look like even the safe haven is just a temporary one at that.

Can nobody else see it? How about India as the next safe haven?….we have once been jocularly called a ‘Gold ETF’, given the underlying $200 bn of gold lying under a billion Indian mattresses. This time, how about our RBI being the most trusted Central Bank in the world? …after Greenspan, not much competition in that Deptt.

I know it runs against everything I have said before, but there is a scenario that we might (temporarily) become a safe haven for currency markets. Temporarily, I say, because the Govt of India is bound to misuse its newfound credibility, maybe take over the RBI, if needed.

But it would be something to watch out for!!!

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