What is the “Eurozone”?
The Eurozone is the collection of 17 European countries that have adopted the euro as their common currency. The 17 member states submit to monetary policy (e.g. – the volume of currency available to manage inflation) of the European Central Bank, but members retain their own spending and taxation policies. Originally, the Maastricht Treaty (which created the euro) stipulated that member countries control their deficit and debt-to-GDP ratios, but these principles were inadequately enforced. In practical terms, the member countries of the Eurozone have a common currency, but they have very different fiscal policies.
What is the European Financial Crisis?
Several European countries have comparatively lavish domestic spending & retirement programs and a lackadaisical revenue system. Simply put, they spend more than they make, so they depend on the world financial markets to borrow money. It isn’t unusual – or necessarily unwise – for a country to borrow funds to invest in future growth or access immediate liquidity. However, any institution – a company or a government – that borrows too much must offer future lenders higher interest payments to maintain access to credit.
The epicenter of the crisis is Greece, so we will consider it as the primary example of a troubled country. In times of stress, governments typically have an advantage that individual companies do not: they can print money to pay the debt. Prior to adoption of the Euro, if the Greek government owned money on Greek bonds outstanding, it could simply print enough currency to pay for the debt. Printing money has an obvious downside: inflation. Printing money would undermine the value of existing Greek currency, but it’s still a better choice than an outright default. Unfortunately, the European Union cannot allow individual members to print their collective currency, so the Greeks cannot simply print their way out of the problem. Further, they cannot simply ignore their debt, because much of it is denominated in euros. If Greece decides to exit the European Union, revert to the drachma, and go into default, the outstanding debt may actually get worse as the revived Greek drachma depreciates relative to the euro.
Greece is one of the smaller countries in the Eurozone (with roughly $305 Billion in GDP). If Greece were the only country in trouble, it wouldn’t provoke the alarm in the markets we have experienced. Greece, sadly, is only one of several countries in trouble. Early in the financial crisis, a pithy acronym of “PIIGS” was coined to highlight those countries with the highest debt to equity ratios and highest interest rates. (Specifically, that acronym stands for Portugal, Italy, Ireland, Greece and Spain.) On one hand, Ireland had to accept an €85 billion euro program from the EU, IMF and others. However, exports and growth have markedly improved and Ireland seems to be climbing out of this mess without additional support. Investors’ interest rate requirements have dropped as Ireland’s risk assessment improves. On the other hand, the bailouts & required austerity measures for Greece have been met with riots and civil unrest, which damages growth prospects and so the downward spiral continues. By the end of September 2011, Greek debt was trading at 40 cents on the dollar and had interest rates over 20%. At these interest rates, the market is presuming at least a partial failure of the Greece government to repay its debts and/or the exclusion of Greece from the European Union.
The drama playing out over Greece will provide a precedent of how the stable countries in the Eurozone ultimately reform or remove less stable countries from the zone. Again, Greece is a small country, but Italy and Spain represent a significant percentage of the Eurozone (with a combined $3.5 Trillion in GDP). Currently, there is no precedent for leaving the zone and no negotiated understanding on how that is accomplished. Efforts to reform the system (e.g. – negotiating peer reviews for member country fiscal policies) are ongoing as a direct result of this crisis.
How does this affect me?
First, prudent investors should be aware of the risks to their portfolio and the crisis in Europe is indirectly affecting global risk and equity markets around the world. We live in a globalized, interconnected system where the strain on an economy thousands of miles away, can quickly and easily damage market prices here at home. For example, 30% of S&P 500 company revenue comes from overseas; the stability of that revenue naturally has an impact on earnings projections and, ultimately, market prices on equity.
Second, international fixed income is a commonly used asset class for many diversified portfolios. As expected, the direct stress to the Eurozone is disproportionately affecting the overseas fixed income markets. Fortunately, investors may select from a variety of investment managers with differing levels of exposure to key markets. For instance, many regarded investment managers eschew direct exposure to troubled Eurozone countries in an attempt to limit risk. Understanding the sources of your portfolio’s risk exposure and managing that risk is an important part of the investment process.
What is happening to resolve the issue?
The Greeks continue to balance externally imposed austerity measures (cuts on spending, government, employees, ramping up their tax base) in return for loans from the stable countries (e.g. – Germany) and the rest of the European Union.
One element of the solution involves lowering the payments on troubled debt. Rather than a complete default, the Greeks hope to negotiate “haircuts” to the private lenders in an effort to keep the debt burden manageable and the country stable. On the surface, a complete default by Greece seems attractive for taxpayers in stable Euro countries – who do not want to be burdened with continuing bailouts of their money squandering neighbors. After all, the bond investors who originally loaned money to Greece assumed the risk of non-payment and they were compensated with the interest payments. Thus, the Greek government and the direct lenders should absorb the damage. The problem is that the European financial system is more entangled than the US model. Specifically, the largest and most stable countries in the European Union (France & Germany) also dominate the financial sector. French and German banks did much of the underwriting and are significant owners of Greek debt. Thus, a complete collapse of Greek debt would damage the already weakened French and German banks, and their economies suffer indirectly. Several banks have written down Greek debt, but there is still enough to become a contagion: a wave of weakness in the global financial sector which has still not fully recovered from the 2008 financial crisis.
October 27th, 2011 to October 31st, 2011: European Debt Deal
The European policymakers agreed on a multipart plan to try and mitigate the damage to the debt crisis. First, Greek debt holders agreed to a 50% haircut. Again, this softens the debt burden to Greece, but the debt holders (banks) are damaged. Thus, the debt deal also included a €106 billion euro recapitalization of banks to maintain financial stability. The Greeks receive another bailout package of €130 Billion euros. Finally, the European Union agreed to an expansion of the Emergency Financial Stability Facility (EFSF) by €1 trillion euros to provide adequate capital to combat contagion in the larger economies like Italy or Spain.
This deal does not immediately resolve the debt crisis, but it solidifies the likely boundaries of future deals and spells out the damages incurred by the parties involved. For example, Credit Default Swaps (which is insurance for bond payments) will not be required given the “voluntary” nature of this negotiated deal. So, German and French insurers (e.g. – FMS Wertmanagement and Groupama) will not need to compensate the owners of the Greek debt (other banks and investment funds). Again, the economic pain hasn’t disappeared - the owners of the debt still take damage - but the deal provides much greater clarity to the situation. As a rule, markets hate uncertainty, so the debt deal was met with considerable enthusiasm. The Dow Jones Industrial average was up 340 points and the S&P 500 was up 3.43% on news of the debt deal.
On October 31st, Greek Prime Minister George Papandreou stalled the deal with a surprise announcement: the government would hold a referendum vote on the package. At best, this delays clarity for many weeks as the Greek government arranges the public referendum vote. At worst, Greece will vote against the package, go through a disorderly default, and collapse - disrupting the entire financial system. Unsurprisingly, the reintroduction of uncertainty has been punishing for global equity markets. We will provide updates on the Eurozone crisis as it unfolds on the world stage.
What can we expect next?
Given the delay of the European debt deal, the news cycle will likely change its focus back to the United States as the debt reduction Super-Committee continues to work through their mandate to cut the debt by an additional $1.2 trillion dollars. The deadline for the Super Committee is November 23rd. The ratings agencies have strongly signaled that they would like to see more compromise between Democrats & Republicans and a larger deal (a $4 trillion deficit reduction), and certainly the United States would like to avoid another downgrade. For more information, please feel free to discuss these issues with us, your investment consultant, and/or fiduciary consultant.