Can a Unified Europe Withstand the Economic Realities of 2009?

In Riga, Latvia’s capital, they are not playing Fredrich von Schiller’s Ode to Joy any longer; rather than drawing on optimism of tomorrow from Europe’s official anthem, Latvians are glued to their television sets, wondering how much financial assistance their country will get from the IMF and from the European Union, and when. For that matter, the music has died down in Budapest too, where Hungarians are beginning to realize that the severe strings attached to the recently approved IMF-EU aid package will place them at serious disadvantages (second-class citizens) in comparison to their richer neighbours to the west for many years into the future.

Europe’s crisis today is best categorized by the fact that “richer” has become a relative term, as the economies of the EU’s older members enter a historical contraction phase, and as Europe’s famed welfare-state principles are being increasingly compromised with each passing day. Credit default swaps spreads (5-years) for Greece, Italy and the Czech Republic have widened to 260, 190 and 185 basis points respectively; the cost of Latvia sovereign bond coverage is heading towards a staggering 900 bps this week.

As if to further prove that Europe is fast becoming “a union of many smaller unions”, CDS spreads for South-Eastern Europe (e.g. Romania and Bulgaria) have breached 500 bps while Ireland risk is being priced at 230-250 bps.

Therefore, one of the key bullish foundations, and turnaround premises, for European ETFs (ADRU, DEW, FEU, FEZ, and PWD) has suffered significant damage of late: the notion of corporate earnings being underpinned by a robust, integrated common market is no longer valid. In fact, all key indicators suggest that European equities retain appreciable downside, despite the huge losses recorded thus far this year. The next major sell signals are now due (in early 2009) from European banks who have incurred massive exposure to Russia (CDS spread 805 bps), and to former Soviet states and satellites, during the previous decade; there is every reason to believe that, if US accounting standards (i.e. FSAS 157 fair value measurements) are applied, the quantum of Level 2 and Level 3 assets on the books of banks in Austria, the Czech Republic, Germany, Switzerland, Spain, Italy and France will unequivocally show that the size of the European stimulus packages falls far short of what is required for purposes of maintaining designated viable capital adequacy ratios within the European financial and insurance sectors.

Latvia is not the only problem state in the Baltics; Estonia is also reported to be considering bailout applications to the IMF, EU and the Nordic countries. Then there is the dismal state of the economy of potential EU member Turkey (CDS spread 485 bps) which is challenging asset valuations on the books of Europe’s major banks. Already, the risks these banks assumed on another potential member, Ukraine, are huge and yet undisclosed in any precise manner; CDS spreads for Ukraine approached 2800 bps a few weeks ago---no quotes are on offer today.

The abundance of depressing economic data from Germany and the United Kingdom released this month is available via any number of news channels—so details of the crisis within Western Europe itself are not being provided in this forum. But, when the internal weaknesses in Europe’s leading economies are considered in conjunction with the near-collapse of the economic benchmarks laid out by Europe’s “poorer” at the point of joining the EU, the bearish case (1-year perspective) for Europe ETFs is further consolidated.

In the final analysis, this deep global recession will test whether the political will for a unified Europe can withstand the economic realities of 2009 and beyond. For the present, however, the final movements of the Ninth Symphony (reflecting Schiller’s Ode to Joy) are no longer an after-dinner staple in cities like Tallinn, Riga, Vilnius, Bucharest, Budapest and Sofia.

Disclosure: Author holds a short position in ADRU

Comments

[No Free Cake:]

Why use such a thinly traded security like ADRU? Why not VGK?

2008 Dec 16 11:47 AM