There is a pile of liquidity (risk capital) floating around and that needs to be invested. So if you are an investment manager you have to go long something and short something else, as simple as that. Now you also know that there is a big hole in the balance sheet of the Euro-area because in the run up to the 2007 blow out, credit was given to borrowers who cannot repay. Now, Italy's sovereign debt comes from before that time, as it did its over-borrowing mostly in the '80s and magnified it by converting lira to Euro at an overvalued rate. But nonetheless it was among the big debtors at the start of the troubles in 2006. Now lets see who the other big debtors were: other peripheral sovereigns and households, who both had gone on a spending splurge in the previous 10 years (unlike italy who was and still is running a massive primary fiscal balance surplus and a current account surplus), households in UK, US and Ireland and to a lesser degree the Netherlands. The creditors were the banks, mostly in surplus countries like Germany, France AND Italy (Italian households are big savers, e.g. see recent report by Credit Swisse that ranks them as among the ones with the largest net wealth in Europe). So an investor with liquidity/risk capital to spare, back in 2007, would have wondered: what do I buy and what do I short? Well, we all knew there was a big hole in the aggregate balance sheet, i.e. assets that were not worth their book (or market) value. The crucial issue was to figure out who would be carrying the can. Well, the UK and US essentially let their currency devalue, thus giving their creditors a hefty haircut, and everybody with a bit of wit knew they would have done that because it was the rational thing to do. So we all figured out they were not the guys to be shorted and, after they devalued, they became the thing to buy. Now, let's see who else we have from the list above. Well, Ireland became the prime candidate for shorting because they had a pile of private sector debt AND the strategic need not to screw-up Europe', as what Ireland does for a living is to act as a tax-lite platform for US multinationals to do business with Europe (can't bit the hand that feeds you)...and also had initially very week political leadership that gave in very easily to pressure from ECB to transform the Irish banks exposure towards their overstretched households into an exposure of the Irish Sovereign, by getting the Irish state to bail out creditors of Irish banks. So, Ireland became one to short. But Ireland was not very big and also, after some initial silly mistakes, they played their cards very well (considerably softening and shifting in their favour the terms of the arrangements with EU/IMF, also thanks to a very healthy national debate on whether the EU was taking the lead). So where to look next? It came to a choice between shorting the banks in the creditor countries and shorting the sovereigns, especially the more indebted ones. Why? Because in the Euro area they were in a similar position. Due to the absence of national central banks who can print money, sovereigns are subject to the same risk of 'runs' as banks, because the asset side of their balance sheet is intrinsically less liquid than the liability side, even for solvent sovereigns. Well the ECB, with its actions but in part also with words, made clear that they were ready to act as lender of last resort to backstop the banks but not the sovereigns, especially not those in the frivolous Club Med. So to many in the markets it became crystal clear that the rational thing to do was to go long risky assets (mostly equity) in countries like US/UK who had already wisely sorted out their debt exposure (mostly through devaluation), about neutral or lightly underweight on banks in creditor countries (waiting to see how the whole thing pans out) and VERY SHORT sovereigns with high debt. That is, policy stance stacked the odds against one player (indebted sovereigns) in favor of equally fragile players (banks in creditor countries with bad credit exposures to both sovereigns AND households corporates). This explains why the Sovereign of a country like Italy became the one to short. In spite of it being solvent, as implied by the large net wealth of Italian households (which means ability to pay tax) and willing to pay back, as demonstrated by the willingness to endure a RESTRICTIVE fiscal policy for the last 15 years (yes, the Italian state runs a very tight ship, with has a massive primary budget SURPLUS, i.e. before interest tax intakes are greater than expenditure by over 70 bio if I am not mistaken). To me at least, that was very clear and that is why I started selling all Italian assets months ago, and moved every last cent out of Italy. Now however I start to wonder. After 15 years of RESTRICTIVE fiscal policy, and after all this mess, wouldn’t the Italian equivalent of the average Joe Soap (i.e., Signor Mario Rossi) start to wonder whether it is worth at all being fiscally disciplined? So the big question now becomes whether the Italians will play along and accept to carry the can for everybody. Let’s see. What should the Italian establishment do? I mean the real establishment…not Berlusconi - it should be clear by now that he’s not the guy in charge in that country. The rational reaction would be to almost encourage a heated internal debate which not only would let out some steam but more importantly would put the Italian government (whoever will be in charge) in a position to tell 'Europe' that it will not be easy to convince the Italian to carry the can all by themselves...so to bargain slightly better and manageable conditions, like say the Irish have done. Will they be so smart to so this? Personally, I don’t think so. I have very little esteem of the Italian elites (again not just Berlusconi, probably the smarter guy among a bad lot). What I am afraid they’ll do is to supinely try and administer the medicine that is being prescribed by their European friends, and they’ll do that in earnest...simply due to incompetence. Some pack mentality now obvious amongst European peers (who BTW are way more competent) will make the medicine only harsher in the face of Italy's weakness, which would be great and solve the bad debt problem once and for all for everybody...except that Italians may decide not go along for the ride. That seems very likely to me after 15 years of fiscally restrictive policies. So the BIG risk, and not so a low probability one either, is a big blowout with some sort of radical shakeup of Italian politics (and perhaps even deeper than that) leading, at best, to a renegotiations of the terms of engagement with Europe and possibly all out abandonment of the Euro with de facto default (redenomination of liabilities in Liras or something along those lines). Then, the can would go straight back to ‘core’ Europe. A good time to start buying volatility on borrowers of these countries? Out of the money puts on their banks are a bit expensive but maybe not so much, and caps vols on Bund yields are very cheap…
Access Investments-Building Awareness - European Union-ROMANIA
Monday, January 23, 2012
A poit of view...
There is a pile of liquidity (risk capital) floating around and that needs to be invested. So if you are an investment manager you have to go long something and short something else, as simple as that. Now you also know that there is a big hole in the balance sheet of the Euro-area because in the run up to the 2007 blow out, credit was given to borrowers who cannot repay. Now, Italy's sovereign debt comes from before that time, as it did its over-borrowing mostly in the '80s and magnified it by converting lira to Euro at an overvalued rate. But nonetheless it was among the big debtors at the start of the troubles in 2006. Now lets see who the other big debtors were: other peripheral sovereigns and households, who both had gone on a spending splurge in the previous 10 years (unlike italy who was and still is running a massive primary fiscal balance surplus and a current account surplus), households in UK, US and Ireland and to a lesser degree the Netherlands. The creditors were the banks, mostly in surplus countries like Germany, France AND Italy (Italian households are big savers, e.g. see recent report by Credit Swisse that ranks them as among the ones with the largest net wealth in Europe). So an investor with liquidity/risk capital to spare, back in 2007, would have wondered: what do I buy and what do I short? Well, we all knew there was a big hole in the aggregate balance sheet, i.e. assets that were not worth their book (or market) value. The crucial issue was to figure out who would be carrying the can. Well, the UK and US essentially let their currency devalue, thus giving their creditors a hefty haircut, and everybody with a bit of wit knew they would have done that because it was the rational thing to do. So we all figured out they were not the guys to be shorted and, after they devalued, they became the thing to buy. Now, let's see who else we have from the list above. Well, Ireland became the prime candidate for shorting because they had a pile of private sector debt AND the strategic need not to screw-up Europe', as what Ireland does for a living is to act as a tax-lite platform for US multinationals to do business with Europe (can't bit the hand that feeds you)...and also had initially very week political leadership that gave in very easily to pressure from ECB to transform the Irish banks exposure towards their overstretched households into an exposure of the Irish Sovereign, by getting the Irish state to bail out creditors of Irish banks. So, Ireland became one to short. But Ireland was not very big and also, after some initial silly mistakes, they played their cards very well (considerably softening and shifting in their favour the terms of the arrangements with EU/IMF, also thanks to a very healthy national debate on whether the EU was taking the lead). So where to look next? It came to a choice between shorting the banks in the creditor countries and shorting the sovereigns, especially the more indebted ones. Why? Because in the Euro area they were in a similar position. Due to the absence of national central banks who can print money, sovereigns are subject to the same risk of 'runs' as banks, because the asset side of their balance sheet is intrinsically less liquid than the liability side, even for solvent sovereigns. Well the ECB, with its actions but in part also with words, made clear that they were ready to act as lender of last resort to backstop the banks but not the sovereigns, especially not those in the frivolous Club Med. So to many in the markets it became crystal clear that the rational thing to do was to go long risky assets (mostly equity) in countries like US/UK who had already wisely sorted out their debt exposure (mostly through devaluation), about neutral or lightly underweight on banks in creditor countries (waiting to see how the whole thing pans out) and VERY SHORT sovereigns with high debt. That is, policy stance stacked the odds against one player (indebted sovereigns) in favor of equally fragile players (banks in creditor countries with bad credit exposures to both sovereigns AND households corporates). This explains why the Sovereign of a country like Italy became the one to short. In spite of it being solvent, as implied by the large net wealth of Italian households (which means ability to pay tax) and willing to pay back, as demonstrated by the willingness to endure a RESTRICTIVE fiscal policy for the last 15 years (yes, the Italian state runs a very tight ship, with has a massive primary budget SURPLUS, i.e. before interest tax intakes are greater than expenditure by over 70 bio if I am not mistaken). To me at least, that was very clear and that is why I started selling all Italian assets months ago, and moved every last cent out of Italy. Now however I start to wonder. After 15 years of RESTRICTIVE fiscal policy, and after all this mess, wouldn’t the Italian equivalent of the average Joe Soap (i.e., Signor Mario Rossi) start to wonder whether it is worth at all being fiscally disciplined? So the big question now becomes whether the Italians will play along and accept to carry the can for everybody. Let’s see. What should the Italian establishment do? I mean the real establishment…not Berlusconi - it should be clear by now that he’s not the guy in charge in that country. The rational reaction would be to almost encourage a heated internal debate which not only would let out some steam but more importantly would put the Italian government (whoever will be in charge) in a position to tell 'Europe' that it will not be easy to convince the Italian to carry the can all by themselves...so to bargain slightly better and manageable conditions, like say the Irish have done. Will they be so smart to so this? Personally, I don’t think so. I have very little esteem of the Italian elites (again not just Berlusconi, probably the smarter guy among a bad lot). What I am afraid they’ll do is to supinely try and administer the medicine that is being prescribed by their European friends, and they’ll do that in earnest...simply due to incompetence. Some pack mentality now obvious amongst European peers (who BTW are way more competent) will make the medicine only harsher in the face of Italy's weakness, which would be great and solve the bad debt problem once and for all for everybody...except that Italians may decide not go along for the ride. That seems very likely to me after 15 years of fiscally restrictive policies. So the BIG risk, and not so a low probability one either, is a big blowout with some sort of radical shakeup of Italian politics (and perhaps even deeper than that) leading, at best, to a renegotiations of the terms of engagement with Europe and possibly all out abandonment of the Euro with de facto default (redenomination of liabilities in Liras or something along those lines). Then, the can would go straight back to ‘core’ Europe. A good time to start buying volatility on borrowers of these countries? Out of the money puts on their banks are a bit expensive but maybe not so much, and caps vols on Bund yields are very cheap…
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2 comments:
Except Germany's current account balance relative to the PIIGs is tiny compared to EU-external sovereigns.
No matter how you try to reframe the problem in market, monetary, fiscal, political or structural terms, Germany is NOT the *source* or cause of the current crises. Though for everyone else's expediency and short term gain, Germany could certainly pay to defer the problems a little while into the future.
Also, as indicated by my response to Anders K, trying to put caps on current account balances directly through Eurosystem payment targets is ridiculous since it would create far more problems than it solves. For one, balance of payments can be seen as a reflection of comparative advantage - who is to say explicitly what is right for a country. Secondly, the strongest economies are diversified and not reliant solely on European demand - rules limiting current account balances would be implicitly directing the volume of these flows and in additional ways is almost a politburo management level of national economies.
The main conclusions of this article is what everyone knows already:
- Germany has well-known and strong fiscal red lines it cannot cross
- some of the debtor nations are too used to consumption binging while everything was good and now are extremely reluctant to pay the price (funny how most ignore the example of those countries that are prepared to put their house in order and already doing so)
- "everyone" sees a Euro break up, if they do not get their way, NOW.
What is far more likely to happen is they muddle through. I do agree with the article in the means with which they will do it is by inflation and most likely to the detriment of the German/creditor taxpayer. Whether the ordinary Germans themselves realise this, or if they do grudgingly accept it, that they may have to "pay out" for far longer than they would like, I have no idea.
I would actually consider it an impressive (though doable) achievement if the EuroZone achieves this without printing or Eurobonds.
The euro is not the gold standard. Under the gold standard each country's monetary mass depends on the gold reserves of its central bank, which in turn only depends on its net exports. When the EMU was created, the weights of each country on the ECB's board depended on its currency reserves and export surplus rather than on its population. But these weights were then fixed. Under a gold standard, these weights would have been reset periodically and Germany would now be controlling ca. 90% of the ECB board votes together with other northern European exporters: if the ECB had not been excluded from the Greek haircut, this would be the case today, because the ECB would have had to be re capitalized.
However, the gold standard is no panacea because it does not take capital flows into account. Capital flowing into surplus countries considered as safe havens (or good investments) generates excessive inflation while capital fleeing from countries considered as bankrupt (or bad investments) generates excessive deflation. Inflation and deflation ultimately discourage trade because exporters want to sell today and importers want to buy tomorrow. The euro is more stable than the gold standard (and more suitable to the EU's objective of economic integration) because the target 2 payment system takes capital flows into account and is neither inflationary nor deflationary.
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