China Trying to Break the Euro?

Last week the Financial Times ran an article written by famous currency trader George Soros. His article was entitled the Eurozone Needs a Corporate Bond Market, and in it Soros touches on one of the greatest weaknesses of the Euro currency; the inability of the European Central bank to control monetary policy across the member states in the Union.

In the article Soros says:

"The euro suffers from certain structural deficiencies; it has a central bank but it does not have a central treasury and the supervision of the banking system is left to national authorities. These defects are increasingly making their influence felt, aggravating the financial crisis...

...The capacity of individual member states to protect their banks came into question and the interest rate spread between different government bonds began to widen alarmingly. Moreover, national regulators, in their efforts to protect their banks, were unwittingly engaging in beggar-thy-neighbour policies. All this is contributing to internal tensions...

...At the same time, the unfolding financial crisis has convincingly demonstrated the advantages of a common currency. Without it, some members of the Euro zone might have found themselves in the same difficulties as the countries of eastern Europe. As it is, Greece is hurting less than Denmark, although its fundamentals are much worse. The euro may be under stress but it is here to stay. The weaker members will certainly cling to it; if there is any danger, it comes from its strongest member, Germany..."

Soros isn't the only one thinking this. In Early February I was also turned onto an article about the deficiencies of the Euro zone which was written by John Mauldin of Safe Haven in his "Outside the Box" column. The article if you are into currency trading is fascinating and I think well worth the read; it's called "Can the Euro Survive." What's important for this post though is that Mauldin includes several very helpful statistical figures in visual format that I'd like you to see.

Mauldin says the following:

"There is nothing in the Maastricht treaty which prevents a member country from leaving the euro, yet the decision to join is effectively irreversible. There are a number of reasons for this, the most important being economic costs. Take Italy which has a history of compensating for lost competitiveness through regular devaluations. If Berlusconi did the unthinkable tomorrow (sorry - nothing is unthinkable in Berlusconi's world), Italy's borrowing costs would explode. My guess is that bond investors would demand double digit returns on a Lira denominated bond to compensate for the dramatically increased devaluation risk. Already in a precarious fiscal position, Italy could quite simply not afford that. So, if any country were to leave the euro, it would more likely be from a position of strength, and only one country possesses enough strength to pull that off in the current environment. That country is Germany. And, although the euro is not particularly popular in Germany, I believe it is extremely unlikely for Germany to make such a move unilaterally. There are several reasons for that - Germany's history in Europe being the most important.

At the same time, the fact that the euro has saved the bacon of more than one country in recent months - Ireland being the most obvious example - should not be ignored. For this very reason, the euro membership is actually far more likely to grow than to shrink as a result of the financial and economic crisis engulfing the world. The issue the EU has to deal with is whether the new applicants should actually be welcomed. Most of those who would want to join will bring plenty of baggage."

And now for some interesting stats to support the idea that the stronger European countries are growing increasingly discontent with some of their lesser neighbors.

Item 1 2007 Unit Labour Cost Index

(2000=100)

Original Source: http://stats.oecd.org/

Item 2: Actual Debt & Age Related Contingent Liabilities

Original Source: Goldman Sachs, European Weekly, 1/22/2009

Item 3: Sovereign Debt Spreads over Germany

Original Source: Goldman Sachs, European Weekly, 1/22/2009

Now for my thoughts on what someone or some country could potentially do to break the Euro or put extreme pressure on the Euro zone if they had enough money. Assuming there was enough capital to pull it off, the play here is to go short the debt of the weakest of the Euro zone members. (I'd say Italy or Greece with Spain not far behind). By doing this you would drive interest rates up on sovereign debt within the countries you targeted. This would create huge problems for them individually, may potentially push them to the brink of default (not unlike California) and would effectively ruin the European Central Bank's day.

In Table 3 above you can already see the staggering difference in debt spreads between Germany (arguably the strongest Euro zone member) and Italy, Spain, Greece, and Portugal (as above arguably the weakest). Increasing the borrowing cost on debt in the weakest countries would require capital infusions from the Central Bank, however the bank would be powerless to stop the pressure on the sovereign debt of the individual countries because, as Soros said, there is no unified European Bond Market.

After pushing borrowing costs upward in the weaker countries of the Union one would then begin shorting the Euro currency with as much cash as they possibly could. By doing this you would be adding additional downside pressure to the Euro, as the ECB in an effort to save the ailing countries you were shorting debt on, would have to be injecting more and more capital to keep them afloat. This would squeeze the entire Euro zone and, in my opinion, the strongest of the countries would begin to say "enough is enough." At which point nationalism would grow stronger, more thought would be given to the facts in Tables 1 and 2 above, and I would speculate some members would consider leaving or not assisting their ailing neighbors.

In either scenario you would be able to create a massive crisis and downside pressure on the Euro would grow significantly. Currently tensions are already high around the world as the economic crisis continues to unfold and many are starting to wonder about Europe's exposure to countries in the old soviet block which is already damaging the Euro's strength. In addition, as I am writing this, Germany just released a statement regarding its assistance to weaker Euro zone members so we know conversations are being had about this issue. The unified debt market problem exists, it's staring the world in the face, and someone with enough power could exploit it.

So who is large enough to do this? Who would benefit from this? China.

China could benefit from this strategy significantly because it has the largest cash reserve of U.S. dollars in the world. Since China holds between $1 and $2 trillion dollars' worth of U.S. currency it has more than enough money to start picking off the weakest of the Euro zone countries and to begin the execution of my plan above. In doing this China would be able to profit from its shorts on the sovereign debt as the nations it targeted began to fall. Then it would also profit on its shorts against the Euro because the Chinese are impossibly long U.S. Dollars. Additionally, if China was able to succeed the strongest states of the Union would end up standing on their own and allowing the weaker countries to go it alone and most likely fail.

If China could accomplish this it would ultimately gain the global financial political clout it is so desperately seeking, and wouldn't have to go to war to obtain it. Last week while trading the EURO / USD pair I noticed something strange. During the Asian market hours roughly between 23:15 and 7:15 GMT a very large player was dumping a tremendous amount of Euros onto the market and buying up dollars; so much so that the market was moving a few cents almost instantly which is HUGE in currency trading. I was not the only person to notice this, and it happened 4 out of 5 sessions (see graph below)

Who in Asia do we know that would want to keep the value of the dollar up? Who in Asia do we know that could benefit from the collapse of the Euro? Who do we know has funded the credit expansion of the United States for far too long, isn't getting any global respect, may have said enough is enough, and taken matters into their own hands? China.

Stock position: None.