Paul Krugman misses an important point in his blog about Germany's current account surplus: It's all due to locking in an advantageous exchange rate at the formation of the Euro and this will unwind if the Euro breaks up.
Here’s the key to the German recovery:
Germany moved from small current account deficits (the current account is a broad version of the trade balance) to massive, and I mean massive, surpluses.
So what the Germans are in effect saying is that everyone should run huge trade surpluses.
May I humbly suggest that this poses an arithmetic problem?
And this isn’t trivial — the adding-up constraint, the point that if Southern Europe is going to shrink its trade deficits somebody has to move in the opposite direction, is the core of the problem.
The Euro exchange rates were based on the market rates on December 31,1998. After this point, exchange rates were locked in even though the conversion to actual Euro's did not occur until January 1, 2002. The Germans are bright so perhaps they did this on purpose or perhaps the increasing current account deficit from 1997 to 2000, which are negative for a currency, was the result of the ongoing German reunification on 3 October 1990 (though that is a long lead time).
The chart below compares the changes in German current account to the PIIGS (Portugal, Italy, Ireland, Greece and Spain.) As you can see a major portion of the German Current Account increase came from the PIIGS.
Martin Wolf did an analysis that concluded that Current Account Deficits were a good predictor of whether a country in the Euro-zone would have a fiscal crisis while budget deficits and public debt levels were not. Efforts to fix the problems of the Euro by controlling deficits and debt will not correct Current Account imbalances. Fixing Current Account deficits quickly requires currency devaluation which means a breakup of the Euro.
If the Euro fails there will be a period in which the new currencies float against each other. This will result in an instant appreciation of the new Deutschmark (DM) against any country that Germany is running a trade surplus with, reducing German exports.
Unless Germany makes active efforts to make sure that countries leaving the Euro continue to have access to credit so they can partially maintain purchases there will be an instant recession in Germany.
After the Euro fails the opportunity for investor gains will be greater in the PIIGS, which can expect increased exports, than in Germany which should lose exports.
While prudent investors will completely exit investments in PIIGS country stock markets and bonds until the Euro-mess resolves itself (except for brave shorts), there will be significant upside in these countries' stocks and bonds once the dust has settled.
The Argentina crisis of 1999-2002 is the best example for investors as it is hard to believe that there could be a messier unwinding of a 10 year peg (to the dollar in this case) and subsequent devaluation. Once the devaluation was complete in 2002, recovery was quick as shown in the chart below.
Even though the economy continued to contract in 2002 after the US $ peg was removed on January 2, 2002, the Argentina stock market (MERVAL) was up 63% in 2002, up a total of 231% after 2 years and 325% after 3 years as shown in the chart below. Adding in the 75% depreciation of the peso in the first 4 months of 2002, shows the sweet spot for maximum returns in $ terms to be after the currency had stabilized. In Argentina this was a 7 month window from May to November, 2002.
The wiki article on this is fascinating reading. In 1999, the Argentina deficit was just 2.5% and total government debt was only 50% of GDP, far below the levels of the PIIGS today. This suggests that not only did the austerity demanded by the IMF (sound familiar?) directly cause the Argentina devaluation but also implies that the same thing will happen to the PIIGS.
Lessons from Argentina for Euro-zone investors:
- The IMF will insist on being paid in full and the ECB seems to be doing the same so private investors will take all the hit from the devaluation of PIIGS bonds. This was 75% in the case of Argentina but there may be opportunities to buy PIIGS bonds at significantly below this in the midst of the crisis.
- Bankruptcy of corporations in devaluing countries will be common, so be careful of when purchasing individual stocks in the PIIGS' stock market until after the economy is growing. Note that bankruptcies seem to peak just after a recovery has started.
- The safest opportunity is in PIIGS index funds and EFT's such as iShares MSCI Italy Index Fund (NYSEARCA:EWI) or iShares MSCI Spain Index Fund (NYSEARCA:EWP). The individual broad country stock markets will probably hit bottom just before a devaluation and then climb steadily. Safest buying will occur after the currency float has stabilized but before the economy has obviously started to take off, a window of several months. Note that if you buy early you can end up being underwater in both absolute and dollar terms for a while.
- An additional benefit in PIIGS index fund investing is diversification away out of the dollar which can be expected to drop slightly against the new PIIGS currencies once these countries’ economies start to grow again.
In sum, Germany's current undervalued position in the Euro zone means German exports will be hurt by a breakup of the Euro-zone. While Germany may not experience an actual economic contraction as it will benefit some from the economic expansion of the PIIGS, the growth in broad market indexes in these current account deficit Euro countries will be far higher than anything that can be projected in German stocks. Dollar investors will have to be careful about buying before exchange rates have stabilized.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.