"Do or do not. There is no try."
Yoda, Star Wars character
The EU and ECB could learn a little something from the old Jedi master. For the last 18 months the European sovereign debt crisis has swirled around global markets like a vulture waiting for an injured animal to die. Europe has responded with timid, half measures, rather than bold initiatives. The markets’ response has been brutal. The Euribor-OIS spread, a measure of banks willingness to lend Euros to one another, has skyrocketed. Equity markets have plunged, and yields on Greek debt have risen astronomically. As a result, the nations of the monetary union find themselves at a crossroads. They have little time in which to act and the choices they make will likely determine the Euro’s fate.
Yoda, Star Wars character
The EU and ECB could learn a little something from the old Jedi master. For the last 18 months the European sovereign debt crisis has swirled around global markets like a vulture waiting for an injured animal to die. Europe has responded with timid, half measures, rather than bold initiatives. The markets’ response has been brutal. The Euribor-OIS spread, a measure of banks willingness to lend Euros to one another, has skyrocketed. Equity markets have plunged, and yields on Greek debt have risen astronomically. As a result, the nations of the monetary union find themselves at a crossroads. They have little time in which to act and the choices they make will likely determine the Euro’s fate.
First let us be clear: Greece is insolvent and, in one shape or form, will most certainly default. Further funding of Greece is money down the rabbit’s hole. Europe would be better off using its fiscal and monetary firepower to shore up the continent’s banks and ensuring adequate liquidity to systemically important Italy and Spain. Bear in mind that the economies of Ireland, Greece, and Portugal, all of which have received bailouts, are roughly half the size of the Spanish economy, which itself is about two thirds the size of the Italian economy. Europe needs to move boldly to prevent contagion from the inevitable Greek default from spreading to other weakened European sovereigns and the continent’s financial institutions. Fiscal and monetary power must be aimed at ensuring that the financial system has the capital to cope with the potential defaults of the smaller three nations and protecting Italy and Spain (we note that while a Greek default appears imminent, such is not the case for Ireland or Portugal).
While stemming the contagion will require aggressive action by European monetary and fiscal authorities, they do not need to recreate the wheel. The tools to contain the crisis exist, the structures simply need to be put in place. A template for Europe lies in the framework the US developed in in the fall of 2008 to recapitalize the nation’s banks and to thaw frozen credit markets. The Troubled Asset Recovery Program, or TARP, was used to recapitalize the US financial system. The Term Asset-backed Loan Facility, or TALF, helped unlock credit markets. A program similar to TARP could be used to shore up capital at European banks, enabling them to remain healthy despite the losses they will incur in a Greek default. A program similar to TALF could be used to lever the European bailout fund to support ECB purchases of Italian and Spanish sovereign debt, likely lowering funding costs to those nations and stemming contagion.
Clearly the sovereign debt crisis is a financial crisis for the individual countries involved. Yet for the Euro-zone as a whole it represents a political crisis. Europe has the financial wherewithal to stem the crisis. As noted above, the model with which to do so already exists. The structure simply needs to be put in place. The question remains, does Europe have the political will to act? Ultimately, we suspect the answer is yes. Despite the political challenges of developing consensus among members states, there are powerful social and economic forces supporting the union, the seeds of which date to the end of WWII. In the aftermath of the Second World War, Europe sought refuge from the nationalistic fervor that resulted in two global wars, each of which nearly destroyed the continent, over a span of three short decades. In 1951, the Treaty of Paris established the European Coal and Steel Community, which resulted in the sharing of coal and steel production among former WWII adversaries. Having worked to build bridges across nations in Europe for six decades, member states have deep, vested interests in the Euro-zone’s success. Additionally, while the US Dollar remains the world’s primary reserve currency, the Euro comprises approximately 25% of global foreign currency reserves. Many nations outside of Europe have a vested interest in the survival of the Euro and the union that spawned it. Simply put, there are numerous reasons, internal and external, financial and social, to expect Europe to make the hard choices necessary to abate the crisis and chart a stronger future for the Euro.
A solution to the crisis likely involves programs similar to those suggested above. Yet to strengthen the Euro and place a strong foundation under it will require something more, fiscal oversight of member states. This is the most sound long-term solution, but given the need for decisive action in the immediate future, it is unlikely to be part of the near-term solution. It is likely to be a goal that the Euro-zone works toward over a number of years and it would enable it to issue its own debt. This idea has been floated to deal with the current crisis. However, it has largely been dismissed due to the lack of fiscal union and the oversight that would come with it. In the near-term, it may be necessary for some of the smaller peripheral nations such as Greece to exit the common currency in order to get their economic house in order and then reapply for membership. This too is a thorny issue, as there is currently no mechanism enabling the removal, or withdrawal, of a member. Yet this may be part of the near-term solution and one that troubled Greece would gladly accept. However, our expectation for the long-term is that the Euro survives by adding fiscal unity measures to prevent the pressures created by profligate spending by member states.
Summary:
Europe needs to create a decisive solution, and quickly, to a problem it has dithered with for 18 months and that is no small feat. Because the stakes are so high, and that the problem truly solvable, we expect a durable solution. Yet, probability-weighting political outcomes is always challenging and one must also ask oneself if one can live with the worst case scenario, even if the probability of such a scenario is low. The stakes are high for not only Europe, but for global markets and the global economy. A disorderly Greek default will likely send global markets into free-fall and the European economy into recession. The effects would reverberate around the world. So what are investors to do? Plunging prices have left equity valuations attractive, especially in developed and emerging markets. Yet there remains significant downside risk should Europe fail to provide a long-lasting solution. As such, we are delaying our high yield bond implementation and closely monitoring the situation while developing multiple options for our portfolios dependent upon further developments in Europe.