Soros Identifies Europe's Achilles' Heel

Includes: DIA, FXE, QQQ, SPY
by: Carlos X. Alexandre

Now that Greece is temporarily out of the headlines, and the deal took place as expected, there's plenty of ranting about how politicians and the financial establishment are sucking the people dry. Yes, that was the idea, and Greece, once again, is not the problem, but rather the first to be caught with its pants down, and only a reflection of a bigger disease: Unsustainable government debt.

We can talk acronyms and complex financial schemes until we turn blue in the face, but the simple fact remains that debt is either paid or defaulted on, and additional debt does not solve the core issue. The economic projections keep flying, and nobody knows whether Greece's debt by 2020 will be 120% or 1,200% of GDP, or whether 130 billion euros is enough, or only the second installment. As a matter of fact, and according to Dow Jones, "a failure of Athens to implement needed economic reforms would push financing costs up to EUR245 billion." Thus, any guess is welcome.

I was reading a Caixin interview with George Soros and an excerpt caught my eye.

Actually, there is a remarkable similarity - a weakness in the structure of the world. The countries that became heavily indebted in euros turned out to be in a similar position to the Asian countries that became heavily indebted in U.S. dollars. Both are borrowing in a foreign currency. You see, this is something that I didn't realize until recently: The euro is not controlled by individual countries. They have no control over issuing the currency. They are in the same position as a third-world country borrowing in a foreign currency.

The statement in itself is not shocking, although comparing the eurozone to a third world country can be offensive to some, but I am at a loss as to why George Soros would convey the message that he "didn't realize until recently" that eurozone countries cannot print euros, or that "the euro is not controlled by individual countries." He has known those facts since the inception of the common currency.

But the message carries a different connotation, and it's as if Mr. Soros has finally accepted the fact that Europe has embarked on a slippery slope with no end in sight, and his vision of an European social nirvana is giving way to the dismantling of the political structure. While addressing the potential breakup of the euro, Mr. Soros reduced the current condition to an extremely simple and clever analogy, although he never once faulted the root cause of the problem: Europe's government spending.

You can't unscramble an omelet. Once you have mixed the eggs together, you can't separate them again. This is actually in a very gradual way happening, slowly.

Then there's that nagging little fact where some bondholders are more equal than others, as illustrated by a Bloomberg report.

The European Central Bank is swapping its Greek bonds for new ones to ensure it isn't forced to take losses in a debt restructuring, three euro area officials said. The Frankfurt-based ECB is exchanging its Greek bonds for bonds of an identical structure and nominal value, the only difference being that they would be exempt from so-called collective action clauses, the officials said late yesterday on condition of anonymity.

Why wouldn't everyone want to be exempt from the "so-called collective action clauses?" And that brings up one additional question: Who absorbs the European Central Bank' losses, if any? One must look at the capital subscription as published by the ECB, and will quickly realize that Germany is on the hook for a larger share of any write-down. That fact constitutes part of the constant pressure to resolve debt issues in a "certain manner," and further highlights the disunion within the union.

The collective action clause may look harmless because it only affects a small group. But the rules cannot be changed while the game is being played, because that is the fastest way to destroy credibility and ensure that fewer and fewer investors will want to play going forward. Is the ECB exempt from the additional hardships yet to come? As Reuters reported that "Europe's banks bleed from Greek debt crisis," the consensus appears to be that the party has only started, and is not an affair exclusive to Greece, I shall add.

"We can't say that the writedowns are over," said Franklin Pichard, director at Barclays France. "Even if some can say that the worst is over, we are only at a new stage in terms of provisioning and not necessarily at the end."

Furthermore, the article points out that "despite the bond swap deal, bondholders could suffer further hits if Greece's economy fails to recover." In all honesty, and considering the economic measures adopted by the Greek government, how can anyone expect Greece to recover without absolute debt destruction?

Lastly and on a different note, Mr. Soros surprisingly stated that he doesn't think that "state capitalism is a very attractive form of capitalism," when asked about China's success.

First of all, as an individual, I'd hate to be subjected to the bar of the state, that my existence should be determined by the state.

Really? He could have fooled me.

Disclosure: I am long SPY, QQQ.