Never Say Never to Bailing Out of the Euro

Dec.21.10 | About: ProShares UltraShort (EUO)

If life were fair:

  1. Banks would not be getting bailouts.
  2. Taxpayers would not be on the hook for bailouts.
  3. And Austrian economics would be given a chance.

... just to name a few. But life is not fair.

If you are sitting on euro debt issued by a periphery country, and said periphery country decides to pull the plug on its club membership in the single currency, it won’t be fair when the value of your debt denominated in euros, of course effectively guaranteed by the venerable European Union, plunges in value.

But you retort: No way. Periphery states such as Greece and Ireland can’t leave. They are not allowed. It would be economic suicide for them to go, as much of their debt is denominated in euro. Therefore the chances of any periphery countries leaving are slim. We draw your attention to this bit of analysis by the GaveKal Research, in a book titled “The End is Not Nigh,” discussing the impact of Italy leaving the eurozone and returning to the lira and redenominating existing euro debt back into lira:

In the event of a negotiated withdraw, there is no doubt that the government would be entitled to rewrite Italian financial contracts, including its own bond obligation, into New Lira. Investors who claimed to be defrauded by such a “redenomination” could expect no support from British or American courts.

There is the principle of lex monetae, a well-established rule of international law which says that monetary contracts should be interpreted by all courts as if they were applying the laws of the issuing country, unless there is specific evidence that the contract was intended to be governed by some foreign law. This means that the judgment of the Italian courts as regard to domestic securities would be recognized and upheld by other jurisdictions. Because Italian government bonds are issued unequivocally under Italian domestic law, they would be regarded as contracts between Italian residents regardless of who happens to own these bonds today. So courts in London and New York would uphold Italy’s right to redenominated government bonds, provided the Italian courts did not strike down the entire currency reform. On the other hand, bonds issued under overseas law e.g. Eurobonds under English law or securities under New York law, might not be redenominated and would continue to be paid in euros.

But what if Italy pulled out of the euro unilaterally (not negotiated)? What if the government created a New Lira by passing a monetary law that was clearly in breach of the (unamended) EU Treaties and therefore illegal under European law? This scenario would create huge uncertainties for investors (hand huge opportunities for lawyers). It is impossible to say what would happen.

In other words, the Italian government is now in a position to kill the euro and wreck the European banking system merely by threatening to withdraw [because of the trillions of euro outstanding debt].

The most likely result of such a threat would be to force the ECB to ease policy and encourage a weaker euro, in order to accommodate the Italian government’s demands. This would certainly be a rational response from the ECB.

But what if the ECB failed to play ball? Or what if Italy’s economic conditions, following the coming tax hikes, deteriorate further? The government could then become desperate enough to start openly demanding a monetary easing and devaluation, as it did in 1992. That time round, the Bundesbank decided to ignore the Italian (and British) entreaties and orchestrated the expulsion of the Lira and the Pound from the ERM [this is where Soros made his big trade supposedly breaking the Bank of England in 1992 shoring Pound and Lira]. This time the balance of power is tilted the other way. The Italian government can blackmail the ECB with the threat of withdrawal and a European banking crisis.

Experience shows that, in confrontations between politics and financial markets, events sometimes move from impossible to inevitable without ever passing through improbable.

So if you are sanguine in your belief no periphery country will unilaterally quit, we think you may want to take another look.

But, if members decide it is too costly to leave the union, then they are effectively stuck in a common currency union without the option of devaluing their currency to help increase competitiveness and induce economic activity, i.e. create wealth relative to she who is sucking the wealth out of the continent - Germany.

Two main options exist for the periphery states: a) sit around and wait for Robin Hood to rob from the taxpayers and give to the periphery to give to the banks or b) go through with ruthless austerity measures that will require years of domestic readjustment to make your economy more competitive (and even then there is no guarantee of success).

Wait. What is that? There is another option? China to the rescue?

Don’t mistake China’s opportunism for altruism:

China urged European policymakers to back their tough talk with action on Tuesday by showing they can contain the euro zone's festering debt problems.

China, which has invested an undisclosed portion of its $2.65 trillion reserves in the euro, said it backed Europe's efforts so far to tackle the debt problems, but made clear it would like to see the measures having more effect.

"We are very concerned about whether the European debt crisis can be controlled," Chinese Commerce Minister Chen Deming said during a dialogue between China and the European Union (NYSEARCA:EU), its biggest trade partner. (Reuters)

Played its part? Then why not disclose the investment size? Is this an exercise in perceptions management? China obviously needs European demand. China also has euro denominated bond investments at risk. And China also doesn’t want to compete against Germany if that means the euro goes to par against the U.S. dollar.

If eurozone sentiment begins to cascade downward, as we think it might with each passing attempt at sovereign bailouts, then there’s an increasing chance China’s house of cards collapses thanks to lost eurozone demand and a struggling U.S. consumer.

Never say never …

The simplest way to play a euro that looks increasingly destined for U.S. dollar parity is through a double-leveraged ETF - ProShares UltraShort euro Fund (NYSEARCA:EUO).

Disclosure: I am long EUO.