An Australian analysis of the Euro debt crisis

Op-Ed: Investors, look out — Warnings of a ‘cataclysmic’ Euro collapse

Paul Wallis

the Digital Journal,

12 January, 2012

SYDNEY - The Euro Circus has apparently decided to go back to high levels of paranoia. New warnings of the risks of a Euro implosion are starting to sound grim, like someone wants to be in a “we told you so” position. It’s not all talk, either.

From The New York Times:

Each week, countries will need to sell billions of dollars of bonds — a staggering $1 trillion in total — to replace existing debt and cover their current budget deficits.

At any point, should banks, pensions and other big investors balk, anxiety could course through the markets, making government officials feel like they are stuck in a scary financial remake of “Groundhog Day.”

Even if governments attract investors at reasonable interest rates one month, they will have to repeat the process again the next month — and signs of skittish buyers could make each sale harder to manage than the previous one.

If that’s sounding like a worst case scenario, it’s not even the tip of the problem. Government debts have to be covered, or the default issue, in which government bonds become progressively devalued, cutting into their value to bond buyers, will happen.

Bonds used to be duller than dishwater, and nobody minded a bit. The theory of a bond is that they appreciate in value, and their yields diminish. This is swings and roundabouts with a twist. If the bond yield, (usually a low, nominal amount) moves up or down, the bond price moves up or down. If one goes up, the other goes down. That’s the problem. Italian and Greek bonds have had soaring yields, trying to attract buyers, while their status has been edging closer to the very un-fabulous junk bond status.

Imagine, now, a situation where the world has to hold its breath every time a European country sells bonds. Investors get jumpy, with good reason. If the European market ever crashes, you can expect the shockwaves to go around the world. Your bank may not hold any European bonds, but somewhere in the food chain, someone who lent to its lenders will.

Now this enchanting little narrative from Fitch Ratings, a major credit rating agency:

The European Central Bank should ramp up its buying of troubled euro zone debt to support Italy and prevent a "cataclysmic" collapse of the euro, David Riley, the head of sovereign ratings for Fitch, has warned.

A crash in the Euro would hit:

Anyone holding Euros, obviously

Lenders to European borrowers, who are inevitably holding Euro-denominated assets

Banks with food chain exposure to Euro debt

Private capital in Europe

US major league companies which are also inevitably connected to the European zone markets in various ways

There are no swings and roundabouts in this scenario. It’s all about the cost of money on the markets. The costs of banks’ lending to each other has been going straight up since the original onset of the Greek situation. That hasn’t changed. Italy’s issues, in fact, made the costs higher. This could start pushing up commercial lending rates, which will directly hit the US recovery.

For China, a major credit squeeze will directly hit demand for Chinese products. A Chinese downturn would have a cascade effect through global markets, particularly if it pushed up the prices of Chinese goods. That’s not an unlikely result, because the Chinese produce on extremely thin margins. They’ll close a factory rather than produce below a margin. The result in the West and around the world could be severe inflation.

There’s another scenario which doesn’t seem to be getting much attention, understandably enough- Europhobia. If enough lenders get put off by the constant attrition of European debt and its related risks, Europe could start feeling a capital shortage. That could have some rather nasty consequences for long term European growth and literally pull the rug out from under the Euro bond markets. The big German banks simply can't provide the capital needed.

Investors aren’t famous for their masochism or their love of joy of giving. The European Central Bank should realize, if it doesn’t already, that there’s only so much generosity on offer. Fitch’s advice is quite sound- Isolate the dangerous debt, in effect quarantine it the way the Americans quarantined their toxic debt. It’s not likely to be cheap, but it’s a damn sight safer than “guess what happens next” is likely to be to the European bottom line.

(Another option would be to allow some discounts and tax exemptions for European banks suffering from debt exposure, but that’d be too much like sanity, wouldn’t it, and wouldn’t make anywhere near as many headlines.)

The market is perfectly capable of stampeding itself into yet another post 2008 situation- Massive loss of capital, crashing banks, and not much in terms of real rebuilding of capital. For the US, a stampede into US dollars wouldn’t be much of a blessing, either. The tide would go out, and people would get left holding an overweight currency or other assets. Matters are not helped by the fact that the US Fed will naturally try to avoid the worst consequences of this tidal event and probably do another Quantitative Easing, reducing the dollar’s value to improve liquidity and the marketability of US products.

This can't go on forever. There's no doubt that people will get sick of this in a hurry. Investors cannot be expected to keep carrying this debt load. The ECB needs to take whatever steps necessary to defuse the immediate problems and progressively eliminate the cycle of debt and get the EU's governments' borrowings on a strong, reliable footing.