The Euro Endgame

 |  Includes: DRR, EUO
by: Stuart Staines

As world economies fall again into recession, the time has come to try to write an update on the eurozone. The debt trap which has engulfed most economies of the eurozone has definitely closed the option of kicking the can further down the road and it's therefore time to prepare for the endgame.

Failure was always a given under this Frankenstein currency structure as I demonstrated by plain accounting identities in “The End Of An Era,” and its path since then has held much resemblance with the U.S. subprime crisis. The finality has been a giant CDO of sovereign debt that has been transferred to the ECB as described in “The EU Poker Game.” The endgame will define the size and reach of this failed experiment. Although there appears to be many outcomes, I will try to show that very few, in my view, have any chance of occurring.

The Debt Trap

The first accepted scenario is to simply continue on the current path of endless bailouts without any debt restructuring. In other words, pray that Germany has not outgrown the past six decades of policymaking that has essentially been an extended national apology. This won’t happen and is apparent as soon as you run the numbers. It's a fact that nominal GDP growth must be above the average cost of debt as a percentage of GDP in order to reduce a country’s debt-to-GDP ratio.

Greece, Ireland, Italy, Portugal and Belgium would have to grow their nominal GDP’s anywhere between 4% and 6%. So we know there is no need to look any further as none of these will ever regain market access if they can’t devalue (Italian nominal GDP has been falling relentlessly for 30 years from 8% in 1980 to 2% now).

Next is the question of Spain and France. They would both need a nominal GDP growth rate around 2%. Seems feasible in a normal environment, although the new normal is nothing like the past. I could use unfunded liabilities for the entire eurozone to make a point that the debt path is unsustainable but I am convinced that these will simply not be honored and therefore don’t need to be funded. Under this approach of considering unfunded liabilities there is almost no developed country in the world that is solvent. At the end of the day, the promises that can’t be paid simply won’t be kept.

Spain is unlikely to see any growth at all without a large new wave of private consumption. The reason again, accounting identities. Spain has had a consistent current account deficit even before the introduction of the euro of around 2%. Since joining the single currency its deficit has grown from 2% to 9%. So growth must come from household consumption, precisely the sector with an elevated debt burden. This is not going to happen with 77% of Spanish savings invested in property and 85% of the population owning at least one home. Home prices will continue falling (already down over 20%) and with that kind of ownership rate it's no surprise the banks are not taking the losses through fire sales which would only accelerate the fall in home prices. No surprise either that you can’t get a loan for a new home in Spain, even with a 60% down payment as the banking sector is insolvent and has now lost access to the Interbank market. No growth coming from consumption, none from exports (which by the way are already running at full capacity so it's not that they are uncompetitive, it's simply that the sector is too small) and a government pressed to accelerate austerity measures. This spells deflation and contraction and no return to the markets for financing either.

As for Belgium, it's simply a basket case of what is going on in the larger eurozone and its imminent political breakup is going to devolve into a political and economic tailspin that will make it lose market access and likely accelerate the contagion to Italy.

The situation in France is a little different as no metric on the surface really appears out of control. One aspect that is likely to prove unmanageable and likely to create extreme social havoc as it is reversed is the share of the government sector in the overall economy. Any reduction in government spending would have a disproportionate effect on GDP considering that the government sector represents 54% of the overall economy. It also employs 22% of the working population. Austerity in France is like openly adopting a new policy of negative growth. France is the cradle of social benefits and any reforms will create immense tensions.

But let's suppose France is no immediate concern and also that the core needs only to bailout the GIBIPS, which is what credit spreads has already forced upon them anyway. Bernstein has run the numbers, which have been picked up by Tyler Durden at Zerohedge. Assuming the Greek Loan facility and EFSM remain in place, the new size of the EFSF to cover GIBIPS government debt rollover until 2013 (an optimistic assumption to say the least) as well as an allowance for bank support at 7% of the banks’ balance sheets would require an additional 1.7 trillion in available funds (including the 20% overcollateralization rule). Given that countries that receive support cannot provide guarantees to themselves, 791bn would fall on the shoulders of Germany or 32% of its GDP (and a near 60% increase in the debt of Finland). Interestingly, that would increase the burden on France by about 31% of its GDP leading to a likely significant rise in its spread over Germany and likely consequent downgrade. If you exclude France from the funding, Germany is left holding the bag for a burden equal to 56% of its entire GDP. In addition, a downgrade of France would lead to a wave of downgrades of most European banks.

The Peterson Institute of International Economics has calculated that the 90 banks covered in the latest stress test by the European Banking Authority, need to roll over EUR4.7 trillion in debt over the next 24 months. That is 38% of European Union GDP! Tells you something about the trend in bank stocks over the next few years. Needless to say, this is unthinkable for Germany.

Germany will not be immune from this recession. With its blind focus on exports and trade surpluses it has financed these by accumulating over EUR1 trillion of EMU sovereign debt on which it will ultimately need to take significant write-downs. As its main clients enter a steep recession and fail to honor their debts, this large manufacturing base will partially transform itself from an exceptionally effective trade surplus machine to a less effective and disturbing source of overcapacity.

The Consensus

The second scenario, which is clearly the market consensus, is that the euro survives through fiscal union. The reasoning is that no monetary union has ever been successful without political and fiscal union. A fiscal union would require a federal system of taxation, transfers and spending and a widespread issuance of eurobonds. The first assumption here is that under this regime, Germany could impose binding rules that would disable the periphery from indulging in large fiscal deficits.

These eurobonds could take the form of blue and red bonds as proposed by Jacques Delpa and Jakob von Weizsäcker in a very thoughtful paper for the Bruegel institute. The Blue bonds would be jointly guaranteed by other eurozone members and could cover the 60% ceiling under EU fiscal rules. The Red bonds would be a pure national responsibility with no guarantees and likely much higher market interest rates. The conversion could take place before or after having restructured the debt of those countries with clear unsustainable debt to GDP levels. The orderly debt reduction, which would have to be synchronized with full support to the banking system otherwise the whole system collapses, would at least resolve the immediate issue of unsustainable debt for the most insolvent countries. This would also reduce the uncertainty about the balance sheets of the EU zombie banks.

There is however one critical assumption behind this plan, namely that this fiscal convergence will naturally lead to competitive convergence otherwise the whole process is moot. Instead, all that will take place is political competition on who gets most at the expense of the others.

As Nouriel Roubini points out, structural reforms show their gains only in the medium term (15 years in the case of Germany to reduce unit labor costs by keeping wage growth below productivity growth). In the short run they actually reduce growth as you shed labor and capital from declining firms and sectors.

Would it not be so simple if it all came down to convincing the perceived lazy Greeks and Spanish to exchange their long siestas for the grim lives of hard working Germans?

Cultural stereotypes are the result of our instinctive need to blame someone for the pain we have to endure. As the pain grows so does our suspicion of each other so well reflected in the recent momentum of extremist parties across Europe. Forget the word "European," there has never been such a sense of belonging in Europe. Only French, German, and Italian flags hang over the balconies of their respective houses. You will only see European flags hanging over touristic attractions, hotels and government buildings, all disproportionate beneficiaries of the introduction of the euro. Putting all the blame on the consuming countries and asking them to behave more like savers is yet again a clear misunderstanding of accounting identities.

Low saving rates are seldom the result of the trade policies of the spender but more often those of the policies of the saver. Remember that overall saving levels are equal to production minus consumption. The German policies, focused on keeping wages at bay and taxing consumption, reduce the value of household income, which in turn subsidize manufacturing. The adjustment factor should be a rising currency that gradually reduces the competitiveness of its exports versus the rest of the world. Instead, in a fixed currency regime, there is no adjustment and German GDP growth relentlessly exceeds the growth in household income.

This imbalance, instead of adjusting, shifts onto the other members of the currency union and increases consumption in those countries with lower productivity (funded by German capital exports). Again, in a sovereign currency regime, the trade deficit would gradually lead to a weakening of the consuming nation’s currency thereby reestablishing its relative competitiveness. In addition, the national central bank could raise interest rates to slow consumption and the rise in asset prices. Not so under the euro straight jacket. Instead, the periphery has no choice than to look powerless at the relentless rise in leverage of the private sector until the debt falls under its own weight to end up in the hands of the public sector.

So the idea that eurobonds and fiscal union will be the solution to the EU sovereign debt crisis rests on a completely false assumption that does not hold the test of simple accounting identities. If the Germans move in this direction, Europe will simply enter a spiral of ever-shorter booms and longer busts rhymed by regular defaults.

By then, the red bonds of the periphery will have taken a new life of their own by funding unmanageable deficits and resulting defaults. The question of exiting the monetary union will simply come back in force. The only reason this scenario has a reasonable probability of occurring is because Germany would not be liable for the debt of other eurozone members in excess of the blue bond threshold. They will have to bailout all their banks but that’s a constant under all outcomes.

In this scenario you want to be short the euro. This is effectively the most likely scenario, unfortunately. The euro will fall as it becomes clear that Germany’s large manufacturing base has not only lost its main export clients, but that these are also defaulting on their IOU's.

Exiting The Single Currency

The next group of scenarios imply some sort of exit and return to a national currency, either by Germany or by the weakest members. In all these scenarios one can refer to the excellent piece of work by UBS.

First of all, there is no legal basis for an exit and any break-up would entail negotiation with all 27 countries of the European Union. This would not only require agreement by absolutely all members (even the one expelled) but also in some countries, approval by referendum. During this protracted process, the exiting country would be in total disarray as bank deposits flee the uncertainty and trade plummets. The orderly exit of a single member, whether strong or weak, appears mostly impossible.

So what about the possibility of a unilateral exit decided on the basis that the costs of exit are lower than the costs of staying? First of all, any exit would instantly lead to speculation of others following. Rightly so, as it would raise the costs of staying for all the remaining strong members (in the event of a strong member exit) or all the remaining weak members (in the event of a weak member exit). Further exits would then naturally follow.

If a weak member exits he will have defaulted in the eyes of foreign creditors on both government debt and corporate debt. Any talks of exit would automatically lead to chaos in the banking sector as depositors would flee the country before government capital controls try to stem any withdrawals. Of course, further bank runs would occur in all other euro member states considered as candidates for secession.

Although the main argument for exit is the large currency devaluation that would occur, the fact is that the seceding country would face huge tariffs against its exports into the euro area that would likely cancel out most of the devaluation advantage, leaving it with no trade agreement with any European Union member.

Finally, nearly all monetary union break-ups have been accompanied by extremes of civil disorder or even civil war, as the vacuum left by the traditional political parties opens the door for xenophobic political parties and wide social unrest.

Should it be a strong country that departs, the appreciation of the currency of the seceding country would be extreme with capital flows from the remaining eurozone fleeing the remaining members. Exports would plummet, hit both by the huge loss in competitiveness and the large trade barriers that would ensue.

Interestingly, in the case of Germany, UBS has calculated that the costs of its departure could cost somewhere between EUR6’000 and EUR8’000 per person (20%-25% of its GDP). In comparison, a default and 50% haircut on Greece, Portugal and Ireland government debts, with the remaining euro area members holding all outstanding government debt of these three countries, would only cost a little over EUR1’000 per person in Germany.

This is a most unlikely endgame for the euro. If it took place, you want to be short the euro as the uncertainty and pain would be simply so devastating for the eurozone that foreign assets would seek to escape absolutely all euro assets.

Alternative Scenarios

As described before, whatever the plan, it must convince all members of the eurozone, meaning that not only all political parties in power must be given the impression that their country will benefit from the plan but they must also be able to convince their constituents. Not a small task by any means and probably the largest drawback for any of these muddle-through options.

The first option would be to separate the eurozone in two, something in the likes of North and South with two new currencies. The banking sector would have to be completely supported, most likely through temporary nationalization.

The stronger northern group would have to assure a smooth transition by offering refinancing guarantees, sizable debt forgiveness and initial subsidies to the southern group. The size of these will be intensely debated and sufficiently large to gain support from the “South” for this alternative solution. Given the large losses already discounted by the market it might not be an impossible task.

There would be the need for the creation of a second central bank, most likely for the northern group of nations, but both would have to work closely and assure financial markets that they will use all means necessary to provide sufficient liquidity in both currencies as well as support banks in the transition. This would most likely require support by the BOJ, the SNB and the Fed.

The first issue in such a scenario is that it does not solve the nightmare this will create for northern companies having a significant proportion of their revenues deriving from southern exports and with liabilities to their domestic banking system. The second issue concerns those countries, which could belong in either group and in particular what to do with France.

France has always seen European integration as a way to bolster its international position, finally gain some international weight in the eyes of the U.S. and put Germany in a position where it could never again try to control Europe (funny how the exact opposite has panned out with Germany stronger than ever but wishing it had never joined). By staying with the southern group it could finally take center stage and no longer be the little adopted brother to Germany.

The counter argument is whether it would not perceive this as simply being the captain of the loser’s club of nations with which it has little in common strategically. Indeed, such a break-up would displace the center of gravity to the East where France has built weak relations. In any case, the question of France will be highly emotive and could alone be the reason why such a plan never sees the light of day.

The third issue is that the Northern group would have to run large government deficits to offset the shock. An unlikely development that will assure that the growth prospect of this group will fall abruptly, weighing on its new currency. So whilst the Southern currency will devalue abruptly, the Northern one would likely fall relentlessly thereafter.

The difference between this scenario and a single country exit is that not only the costs are better distributed amongst the two groups of nations but it would also avoid the emergence of penalties and tariffs on trade. The downside is that there is not enough homogeneity for a clear cut between the two groups and recent experience by the northern group of nations makes the whole idea pretty unattractive. Here again, low probability outcome and very negative for the euro.

A Solution?

Another alternative was explained by Francois-Xavier Chauchat at GaveKal Research and is to take the euro project on step backwards whilst keeping it alive. Under this scenario, the euro would become a common currency similar to what the ECU (European Currency Unit) was and each national currency would have a fixed but exchangeable rate against the euro.

Initially, there would be a devaluation of the GIPSI currencies but the euro would remain the currency of the countries that do not devalue. The euro would therefore also remain the European single currency as far as the rest of the world is concerned.

The ECB would continue to manage it and each country that has returned to its national currency would see a debt haircut equal to the size of the devaluation (if the Drachma is devalued by 60% Greek bonds would see a haircut of 60%). All bank accounts would be switched overnight to the new currency and each of those countries could then recapitalize their bust banks with local currencies.

The costs for the corporate sector remain but by imposing a fixed exchange rate after the initial devaluation (that may however be adjusted) should somewhat reduce the level of uncertainty and enable trade to recover faster. The costs of supporting the banking system of the core would remain also but these are inescapable anyway and are nothing in comparison to the costs of a blank check across the entire eurozone.

In my opinion, this is by far the best option. It would enable the European Union to decide whether it should continue with further integration or not (by eventually accepting some of these countries back but this time with Germany playing its part of raising domestic consumption). Some countries, strong from their recent experience, are likely to simply decide that it’s not in their interest to join anytime soon. Germany would regain a strong foothold in the ECB after having of course contributed massively to its recapitalization. It would also be the only outcome that could gain acceptance in a popular vote.

This would strengthen the long term perception of the financial community regarding the euro and might well be the only scenario under which the euro does not fall below parity against the dollar. Ironically, China would be holding the bag. Its obvious policy of buying its way into European politics through debt purchases will have failed.

Euro Or Not Euro

In summary, a step backward is the alternative offering hope for an orderly convergence of the different European economies through new currency equilibriums that favor each individual country and gradually correct the imbalances. It would then leave time for the European Union to decide what is best one step at a time. Most other scenarios simply trigger a collapse of the system and are therefore unlikely to be pursued.

The consensus has put all its chips on the remaining outcome, namely complete fiscal union. Although this is not a viable solution it might well be the chosen path.

Interestingly, the ECB has positioned its balance sheet for the most unlikely outcome, the one in which no debt restructurings occur. The ECB would then continue to take advantage of Germany who ultimately holds most of the burden on its shoulders but has only one vote on the ECB executive board. In a desperate measure of trying to fend off the imminent attack against France’s sovereign spread levels, the ECB has accelerated its transformation in a giant but insolvent lender of last resort for both the banking system and the governments of the periphery.

I am not saying there was another choice in the absence of a clear political roadmap, but the level of denial has been as elevated at the ECB as amongst other political leaders. The collateral posted is worth much less than pair, whether GIPSI sovereign debt or Irish and Spanish ABS, and will end up on the balance sheets of the core. By running the risk of forcing Germany out of the single currency by monetizing all European debts, the ECB might be planting the seeds for the collapse it has been so eager to avoid.

This giant CDO waiting to default will cause a large devaluation of the euro in all cases. It's time to go short the euro and stay short as long as this step backward approach does not gain momentum, whilst hoping or praying it eventually does. The future for European assets is bleak and I would sit tight a little longer on the CDS trades I suggested in my last article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.