As in 2008, when global financial institutions were under attack, we are now facing a solvency crisis. This time the issue is eurozone sovereign governments.
Make no bones about it, the EU’s trillion dollar gambit has worked and a melt-up is underway because near-term liquidity issues have been put to rest. But, this is not a liquidity crisis; it is a solvency crisis. And unless meaningful reform is taken in the eurozone, this crisis will re-appear in due course.
Overnight, the eurozone put together the European Stabilisation Mechanism programme, a hefty plan to provide fiscal support to any eurozone government that runs into difficulty. While details are still coming into view, the euro and equity and bond markets have recovered tremendously. Meanwhile credit default swaps have fallen (see Marc Chandler’s pre-market summary here).
But, before we start popping the cork on the champagne, we need to realize that this stabilization mechanism and the developed market (DM) central bank swap lines only resolve liquidity issues. The genesis of this crisis is not liquidity, but solvency.
As I outlined in my last post on Germany (The Soft Depression in Germany and the Rise of Euro Populism), Germany has undergone extensive labour market reforms which Greece and Spain in particular have not. This makes Greek and Spanish labour forces uncompetitive vis-a-vis other countries also locked into the currency union, most notably Germany. The result, with the Euro well above its launch rate of 1.17 to the US Dollar, is international uncompetitiveness. Combined with extremely low interest rates, the result is a gaping current account deficit.
Unless the eurozone attempts a beggar-thy-neighbour massive devaluation in the Euro, this closes off the export escape hatch for Greece and Spain. Therefore, in order to bring down enormous budget deficits and prevent national bankruptcy, the only option left is internal devaluation – across the board wage and spending cuts.
Ireland, which has faced similar pressures, is embarking on a path of internal devaluation right now to reduce their deficit. But reducing consumption demand at a point when the primary budget deficit is already double-digits still leaves the solvency question open. And Greeks have rioted to show the resistance to those kinds of measures.
My conclusion, therefore, is that while the pressure is off temporarily, Greece will eventually default and restructure their existing debt. Their gross debt and interest levels are too high. And the deficit level cannot be closed without a civil revolt or a collapse of the economy. Moreover, given that the new facilities are senior to the existing debt, the loss of principal, which S&P previously gauged to be 30-50%, will be much higher, say 50-70%. So, huge losses are eventually coming on Greek sovereign debt. The question is when.
But what about contagion? Greece is small, but so was Thailand when it precipitated the Asian Crisis – which eventually brought much of Emerging Market (EM) Asia as well as Russia and Argentina. Once the sovereign default genie is out of the bottle, markets will be stressed until countries can demonstrate clearly that they will not default. So beyond, Greece, the questions go to the rest of the Eurozone and to EM sovereign debt as well.
Monday morning, Rashique Rahman, the head of Morgan Stanley EM Macro Strategy, opined about looking beyond the short-term relief rally. He wrote:
We see three implications for EM from the official announcements.
First, the immediate-term market reaction to the Ecofin EUR750bn stabilisation package has thus far been predictable, with risk markets recovering from the weakness seen in prior sessions. The prospect of ECB public and private bond purchases is also likely to reinforce the favorable immediate-term market reaction. We expect to see a sharper initial recovery for CEE currency, credit and rate markets (Box 1). However, both the potential for fiscal consolidation and therefore slower Eurozone growth more immediately and the fate of EUR convergence longer term, are likely to lead to CEE underperformance beyond the rebound seen today.
Second, the provision of USD swap lines by DM central banks – and reinstatement of the ECB of 6M tenders – are likely to ease recent funding market pressures. We are monitoring DM funding markets closely. This is crucial for EM asset market prospects, in our view, given the reliance of EM on DM funding of its external debt rollovers. Liquidity provision is a net positive for EM, and if coupled with lower-for- longer DM base rates, suggests reinforcing the dynamic of net private flows to EM economies owing to robust EM economic growth and solid relative macro fundamentals. We highlighted the potential for near-record inflows (USD1.1trn) to EM economies in the next 12M – but emphasize that this dynamic is likely to play out over the medium term.
Third, liquidity provision or not, sovereign credit risk has not gone away. Our work suggests ongoing deterioration of DM sovereign creditworthiness going forward, manifested by further downward credit rating pressure. Additionally, the transference of periphery Europe indebtedness to that of core Europe via the stabilization fund – and further, via ECB purchases – bears very close monitoring. Contamination to the core (of DM) lies at the heart of contagion for EM – which again is manifested through DM funding market stresses. (emphasis added)
My takeaway from what Rashique is saying is threefold:
- Solvency issues remain in the eurozone – and while the liquidity issues have abated, the socialization of losses beyond the eurozone periphery will be a longer-term negative for all of the eurozone including France and Germany.
- The risk seeking return mentality which has buoyed EM asset classes is now shifting as evidenced by the decrease in EM fund inflows. This means contagion into EM is a real issue.
- EM Europe is clearly the most vulnerable outside the eurozone given their dependence on trade flows to the eurozone and the fiscal imbalances across that region. Countries like Latvia, which grew again last quarter, are likely to feel renewed economic pressure.
Below is Rashique’s full report and a related one "Fast-track to Fiscal Union?" from Elga Bartsch and Daniele Antonucci. In my view, the EU must not relax into a problem-solved mode. We saw this after Bear Stearns in the US. This crisis is far from over and the fiscal union talk needs to happen sooner than later.
Update: Note, my call for consensus on fiscal union is not a call for fiscal union. I don’t think that is workable (see this post). Rather it is a call to recognize that more is needed than liquidity to deal with the longer-term issues. And the eurozone needs to decide what type of mechanism to use to do so. Also note that Rashique’s suspicion that further credit downgrades are coming has now been confirmed by Moody’s.