Saturday, December 24, 2011

Euro-Contagion: A Holistic Perspective

It has been more than 2 years that we have been hearing about a potential Euro-contagion and significant risks that come along with it. I am sick and tired of the cliched 'Stocks Rise on ECB/Euro hopes', 'Stocks Fall on ECB/Euro hopes' continuously for the last 3 months or so. As I have been putting up my hypothesis, again would like to remind readers that the Sovereign Debt per say is not much of an issue. All the major Euro-areas put together have an estimated 5 trillion dollar debt [based on what is published on Bloomberg and Yahoo Finance these days], that no doubt is a short-term issue but not something that will pose big challenges. I have myself lost count of the number of instances that I have mentioned that there is enough historical evidence that countries have defaulted and yet bounced back as shortly as 12-24 months as far as Sovereign Debt issues are concerned.

On a fundamental level, this could be a severe problem no doubt because the debt that is about to mature in the next 6 months in the Euro region pertains to notes issued 10 years ago i.e. they are about to mature and the concern is if there is a problem to service debt that is 10 years old and the countries are now facing challenges to service that debt and issuing new debt, this could be a recurring problem. That is true and the bottom line is that this has been happening for more than 70 years now with all countries of the west. Again, readers must be aware that Debt as a Percentage of GDP is far higher in case of US, UK, Japan as compared to emerging economies like BRICS, or for that matter the European nations. For the record, these countries have Debt to GDP ratio in excess of 400% or 500%!
Is debt default something new? An emphatic no!
Russia and Brazil of which Brazil changed the entire economic landscape with one short term shock of 6 months. Russia has done it at the back of oil; as recently as 2009, we had Dubai struggling and Abu Dhabi made sure things did not go out of hand [and of course internally extracted its pound of flesh] The most significant difference between the earlier instances and current instance is excessive financial engineering.

Lehman Brothers and the entire mortgage crisis of 2008 was a result of financial engineering and yet again this time the problem is financial engineering on derivatives on sovereign debt than sovereign debt itself. Considering the fact that currency and fixed income derivatives can be leveraged anywhere between 10 and 400 times in the market, the excessive  speculative bets lying in the underlying sovereign debt is what is keeping the markets jittery. It is a complete lack of governance and regulations that any punter can put at stake some money and place bets on who is going to default first. Even now, nobody knows what is the exact amount at stake that is lying in the bets, very nicely conjured up as 'Credit Default Swaps', 'Debt Swaps' etc etc etc that are the real source of the problem.

Is there a way out - yes there is and the most simple way is to make all swaps, options, swaptions null and void outright as far as sovereign debt is concerned - period. It is a one time shock that won't last more than 12 months and cleanse up the entire system once and for all. After that, it is just a matter of looking at individual countries and figuring ways out

[Please note that these are generalized opinions on countries and I mean no offence whatsoever to any person of any nationality. I expect readers to appreciate the spirit of this note than getting lost in heuristics]

1] Greece: This is very prblematic; the Greeks want everything on a platter without bending their backs or mending their ways. What is so special about being a Greek government servant that entitles one to 5 weeks of paid vacations and exhorbitant pensions etc etc etc? What are the resources at hand? How do we get productive and make something meaningful out of the economy? Unless they get their act together collectively in this regard, Greece will be a problem forever. This is one spoilt child that must be abandoned completely until habits do not show remarkable amendments. No Troika monitoring nothing - just abandon this child and let it pledge all that it has [most of it is already pledged] and ask the government to go back to Goldman Sachs with whom it made ponzi schemes of all formats. Let them sort it out.

If Indonesia, Thailand could bounce back even after such a significant currency crisis with excessive devaluation, I see no reason why Greece can't do it. Overnight, the currencies of Indonesia etc got devalued by a factor of 1000! There are governance issues and it is very common to see some major natural disaster in the North Western Gulf of Indonesia every year. Yet this country has managed to marshal resources as a whole. The country exports a lot of furniture, apparel to all major retailers of the world and has a booming local market as well for consumer goods. It does manage to attract a lot of tourists and expatriates. The reason is simple - people realize the importance of living within means, being productive and they do venture out in other areas of South East Asia for employment opportunities, most notably in the real estate development of Singapore / Malaysia, in the mines and oil fields of Malaysia - simple.

2] Portugal: This country is already showing remarkable signs of improvement and will get better and better slowly. Some factories have started producing again, shops are open all 7 days a week now and hence opportunities are coming up. Temporarily wages have gone as low as 400 Euros a month but there are people who realize the importance of working and getting out of the crisis. With Lisbon airport as a major gateway airport to Latin America and the close ties with Brazil, slowly but surely this nation will get out of the crisis pretty soon. As I had mentioned earlier, one thing gaining a lot of popularity in the manufacturing segment of Europe as a whole is proximity sourcing and Portugal is fast encashing opportunities in such areas [Poland was an example that cashed in on low wages and skilled work-force to get a fair share of the ITeS business and was pretty successful as well]. Portugal can do it for manufacturing pretty well.

3] Ireland: Again the government and people both are very clear about the fact that they need to make amendments to their ways and move out of the crisis. For the short-term, if there is a demand slowdown, of course they will suffer but then the Irish in general are pretty strong minded people. If push comes to shove, they have it in them to do what it takes to get out of the problem. Skilled workforce, English speaking skills, and manufacturing prowess - it is a shame that it got into this kind of trouble in the first place and frankly, my personal opinion is that the Irish are far more deserving than Greeks and must be allowed to participate in the Bond Markets as soon as possible.

4] Italy: The demographics here are mixed as there is clear bipolar sections of society here. One similar to Portugal and Ireland that is very clear that amendments are critical and the other more like Greece still living in the false glory of the past. The bottom line though is that there is enough talent and agricultural resources in this country to get it back on the path to success. It will not happen overnight but the talent is there, the resources are there. Governance is an issue and probably for Italy, rather than allowing it access to Bond Markets as a whole on sovereign basis, one could be selective with corporate bonds, specifically of manufacturing companies and it can wriggle its way out. One must not forget that when it comes to productive farming using conventional methods, the farmers of South Italy are actually the ones who migrated most to America and transferred the agricultural cultivation knowledge there!

Italians are still pretty good with design, be it furniture, fashion or automobiles. Regardless of how badgered Fiat's stock prices are, one cannot take credit away from Fiat for the robust engines that roll out of this company's factories.

5] Spain - The election has been successful with a new ministry in place. The government leans a bit to the right but this change is for the better and one must not forget that it was this government that actually got Spain into the EU and Euro in the first place. Again, plenty of agricultural resources [vegetarian as well as non-vegetarian] and there is a silver lining for a lot of corporations if they really take a holistic view. the real estate market, both residential and commercial is badgered to the core and still there is room for another 15% to 20% correction. Spain amongst European nations has been second to the Nordic European countries when it comes to Clean and Green Energy with a lot of investments in Wind Energy. The fact that most of the unemployed workforce is now about to come to an end to social security grants and already unemployment is at a record high, it is potent ground for car makers and engineering goods manufacturers to set shop here. Moreover, tourism will be an evergreen industry for Spain.

So in a nutshell, just as in case of Italy, Spain has the potential to wriggle its way out of the crisis as soon as possible. A major reason why prospects for a Spanish default is highest at the moment [whilst all are looking at Greece and Italy as the smallest and largest] is that it is making a grave mistake by auctioning short-term bonds. With a clear mandate of cleaning up the banks' balance sheets and forcing survival of the fittest, Spain actually can explode like a dynamite as far as Euro-contagion is concerned and one can be pretty sure that the newly elected Rajoy of Spain will do exactly what Brazil did a couple of decades ago. They should be actually auctioning longer maturity bonds even if it means paying a slightly higher yield than shorter term low yielding bonds that will only compound the challenges.

6] France: Again grappling with a lot of challenges, and this is a very strange country one must say. Yet another example of a country living in the false glory of the past and the workforce here is quite problematic. Strikes are as common as eating cakes for dessert, too much state control on healthcare costs whilst ground reality is that there is not much talent left in terms of doctors and nurses in France and likewise in Education. There is not much talent in the workforce pipeline either and there is a huge chunk of population in retired status and they have been promised a host of benefits as far as state pensions are concerned. It is not possible to go back on these benefits now because it was a promise made by the state and one cannot take away the fact from these old people who diligently paid all their taxes and social security obligations in their hay days of work. That the subsequent governments ruined the economic health of France is not a fault of the currently retired people.

Some hard decisions need to be taken like France that is making gross mistakes at both state levels and corporate levels. It needs to give up loss making Air France-KLM at the earliest and just retain the terminals. It is a hard decision but is the best decision as the entire mechanism is burning holes in tax payers' money and there is simply no reason to continue this business [Air India in India is being retained just to appease the political votebank and for personal gratification of politicians in siphoning money off contracts] Air France is a classic case of retaining 'national pride' and 'hoping' that things will turn around in future. A better alternative would be to just retain the airline as a freight carrying airline and charter out passenger aircrafts.

As one can see, for all PIIGS nations with the exception of Greece, there is no problem as far as sovereign debt is concerned. Then why all this ruckus that keeps buzzing around all over the place? In fact a few days ago, the central bank of France raised a valid question to rating agencies and fixed income markets overall - Why point fingers at France when US, UK have almost 500% debt to GDP ratio [well as usual he did try to take a dig at the UK] Well with that logic, have we not seen SnP downgrade the status of US debt? Did that stop Treasuries from rising and Dollar Index roaring? This is where a partial answer to the paradox lies - US, UK, Japan all have rights to print their own money; either directly or in the form of QE or in the form of forex interventions but they do have their rights to print as much money as they want [and I agree there is of course a logical consequence to it and that is inflation; the more a country prints money without growing GDP, the greater will be the inflation - no 2 thoughts about that]

Coming to think of things in the Fixed Income markets, fundamentals and inflation logic apart - as a holder of US, UK, Japan debt, one thing is for sure - they can be redeemed with the central bank at any point of time in exchange for currency [reiterating again, devaluation, inflation, net present value etc etc etc apart - they are valid points but I am keeping out of that for now as the differential in terms of basis points or percentage is something that one can lick once and move on]

As far as the Euro debt is concerned, it all boils down to one country and that is Germany; in the hay days of the Euro, all countries could freely issue respective countries' treasuries denominated in Euros and that was no problem - to the extent they were Euro denominated, bond markets lapped them up; however, in the heat and excitement, literally everybody forgot one critical thing;

a] The countries need to grow their GDP in Real Terms
b] The authority to print Euros lies solely with the ECB i.e. Germany only

For Germany, this proved beneficial; after all, intra-Europe is a very big market for Germany; by enforcing the Euro, it retained a lot of control, helped all EU countries with cheap imports against a strong Euro and things were hunky dory. Just as in case of the dot-com mania or the US Mortgage mania, there was a mania here too - the flawed model was that things will be hunky dory for perpetuity!

My understanding of the situation is that there lies a 2 fold problem here; the EU member states assumed that regardless of what happens, Germany is going to ensure survival of the Euro and EU; Germany assumed that for a short term give-away, member countries would fall in line well before push comes to shove; as the adage goes, if you assume, you end up making an a$$ of u & me!!!

So this is where we are today; neither did member countries care to really grow the economy and just enjoyed the ride thinking ECB [read Germany] will do the needful; everybody missed out on the fact that Germany has experienced significant challenges of hyper-inflation as a consequence of money printing and hence very very stubborn to take the easy way out [and really have to hand it over to the Germans for being so insightful about the consequences of money printing; takes a lot of courage to stick to that stance especially in the West] Is it any surprise that even in Fixed Income Markets, the Bund carries so much more value than a Treasury note?

Now unfortunately that everything has boiled down to Germany - there are only 2 options

1] Print money - this option undoubtedly will put all markets and commodities on steroids but lead to one outcome and that is inflation - not just above average or high inflation but hyper-inflation. Simply because all the underlying assets [real estate, resources etc etc] in Europe are in such a badgered condition that printing money is only going to compound the challenges. With elections around the corner in Germany and such a painful experience that has taken years to turnaround will all fall apart by taking this easy option.

Moreover, it puts Germany in a very bad position for having resisted this option for 2 years, getting so many governments toppled [they would have occured any ways sooner or later] all to just end up printing money? Isn't this the immediate solution proposed when the Greek crisis had first surfaced? If this is what ultimately were going to happen, why did Germany have to hold so many countries, banks and people at large literally at ransom? This could have been done a long time ago and today probably nobody would be even discussing these issues! All markets would have been at all time highs [regardless of the plight of mango people!!!]

b] Germany sticks to its guns and says - forget it; it was a mistake to think about EU and Euro - we enjoyed it for 10 years, suffered for 2 years, tried to resolve it but there is no way out. We took the lead in starting this - we take lead in trying to end this. Rather than keep doing all sorts of nonsensical stress tests, orderly defaults, disorderly defaults etc etc, we work out an easy way out - Germany will exit the Euro and return to the Marks like in the good old days. Overnight, the DM will almost certainly end up being the strongest currency after that of the oil rich nations. No botheration whatsoever about the debt crisis etc etc - to each his own and we move on.

Easier said than done. One must not lose sight of the fact that most of Germany's output needs to be consumed. And in today's hot, flat and crowded world, whilst Germans still have an edge over engineering, it is not as if it is some razor's edge. Local consumption of German goods [i.e. consumption in Europe] goes for a toss, all tenders that normally go through a fierce battle between USD / GBP / JPY terms and EUR terms go away; for sure there is no way Germany can compete on the basis of prices - next to impossible. So whilst the entire media is talking about UK, France being marginalized basis what happened a few days ago, the decision to wash its hands off the problems [and idealogically there is no reason why Germans should bear the burden of somebody else's misdeeds] will end up making Germany marginalized completely!

Hence I deliberately said this is indeed a Catch 22 situation for Germany; Heads = Germany Loses; Tails = Markets Win!!! And regardless of who wins, the entire world will suffer consequences.

So trying to put so much context into the real content - there are no easy answers to the Euro contagion that we are talking about. Any attempt to find an easy way out is futile. So in this aspect, Merkel is right [that she is doing it for political mileage is a different thing all together] Just as in case of the mortgage crisis, yet again the root cause of all problems lies with the bankers. For a change this time with the Fixed Income bankers who have over-leveraged positions on debt for GOD alone knows how many multiples.

Unfortunately, no politician is willing to bell the cat or take the bull by the horns literally and figuratively; what haircut are we talking about on Greek debt? Was the banker sleeping or was on an overdose of substance abuse when s/he agreed to lend money to Greece? This is nothing short of what happened in the mortgage crisis; WTF is 'Stated Income' I can print out a nice 'Stated Income' sheet showing my net worth in millions and is that all that is needed for me to take out a mortage? I could probably take a private island in the Bahamas or Hawaii if it were that simple - so I simply cannot accept the tantrums that Fixed Income managers keep harping about losses on yield by taking haircuts - first of all out of the greed for yield you gave money to somebody who cannot service that debt [just like a pizza delivery boy could buy a mansion in Orange County, California - please don't get me wrong; I mean no offence and have complete dignity of labor. A pizza delivery boy is as much a human being as you and me but lending millions of dollars to him for a 3000sq feet villa?? On the basis of stated income???]

No prudent lender would do that - period; even more shameful is the fact that the bankers did all of this knowingly for personal gratification and let us not forget - it was not their own money in the first place! Hard working people, who strive to create things, earn a living and save something - it is the collection of millions of such investors.

So back to the Euro contagion - the real solution is extremely simple and straightforward - it will lead to pain for the short term but it is high time this step is taken - once and for all, forget unwinding all the long/short Swaps, Options, Swaptions and all forms of mumbo-jumbo; forget repeating an Operation Twist or whatever - just get rid of everything - the real world is simple and we dont need all these formats of financial engineering - to hoots with the bankers and their operations to ruin our lives; we have had enough. With this aspect taken care of, Germany is out of the Catch-22 challenge; it can then decide whether to stay with option1 or option2 i.e. continue with the Euro or let all countries return to respective currencies. The change will be painful no doubt but this at least get things on an even keel.

The world is not going to get over with this; people need food on the table, roof on the head and some appropriate clothes to wear. Rest, slowly but surely let the best people who battle the crisis win; As late as in 1977 Dow did not even breach the 1k mark! It was in the roaring 1980s when baby boomers took Dow up to new leaps and bounds. Likewise for the other indices as well. IMHO, it all started in the early nineties that the West realized that financial engineering could help take things to higher levels without too much effort on the economy. There is a large amount of details with exact accounts of what happened in Bob Pretcher's book, Conquer The Crash and it is a highly recommended read.

Just as it happened after the dot-com bust, the housing crisis bust, the people threating of dire consequences are bankers. And they are threatening people as well as governments with the simple mantra - if the contagion is not stopped, then credit markets will freeze for people and corporates. It is time that the governemnts keep spines erect and say to hoots with you. Rather than channel tax payers money to bail out the banks and create some bad banks to absorb all the rubbish, it probably makes more sense to create some good banks that lend out to people. The whole system needs a rejig - whether that will happen is anybody's guess.

So to summarize the whole thing, Germany is the only country that can take some action right now to resolve the issues. It has 2 options and both undermine its financial and sovereign strength. The sovereign debt by itself is not a problem. It is the excessively leveraged punter positions by bankers in the derivatives market at the back of savers money is what will blow up the Euro crisis. Let the news not fool you again and again - markets have discounted a large spectrum of probabilities; everything is not discounted on the stock market alone [and for puritans, take a look at the KBW Banking Index and it shows how markets have discounted for troubles in banks already!] The yields and spreads in the Fixed Income markets also show that markets have discounted a lot of bad news.

Why this entire verbose saga is so important for the common people? It reflects the importance of cash, the importance of choosing which bank you keep your money with [not much of a problem in India at least] It also is a clear indication, steer clear of the noise - reporters will do what they are being paid to do i.e. fill content. Deleveraging of debt is a reality - it is bound to happen and when that happens, market volatility will be high. we are talking of more than 7 decades of debt [just have a look at Brian Whitmer's video in Yahoo Finance] and about 12 years of senior debt from the inception of Euro.

Identify the accumulation band and invest in tranches - keep some cash in hand always. There are 2 extremes being discussed and as usual we have Bob Pretcher on one end of the spectrum talking about 'Deflation' and we have Nadeem Walayat on the other end of the spectrum talking about hyperinflation. I admire both of them but in the end, I am happy to have my own independent line of thought as well. I agree with Pretcher Jr on the fact that economy is contracting due to squeeze in business credit but as of now, don't agree with his call for deflation; when customers in reality start paying less for goods can we expect that to be true. I also don't agree with Walayat that markets will go to all time highs once again - it is a low probability outcome for markets as a whole.

Thanks for taking out the time to go through this lengthy article - if this has managed to give you a holistic perspective and take remedial actions without getting distracted with news flow, I will consider this effort to be a success. Enjoy your weekend and the seasonal festivities.


Suraj said...

Dear Nagraj Sir,

Thanks for detailed n in depth article. Please keep it continue.

winner said...


My respect for you and your knowledge has grown manifold,


GreatGambler said...

well written in layman terms
Thanks for your effort

Govind said...

Awesome post Nagaraj ji..Keep up the good work..

sometimesbullsometimesbear said...

Stupendous research.

dotcombust 2000
mortgage crisis 2008
EU crisis 2016

As per the eight-year cycle theory
why not get ready for a market bust
in 2016 and this time it wil be the EU crisis bomb :)