Monday, June 1, 2015

Euro Zone Crisis and Why It Will Be Good For Break-Up

For the last 5 years now, the PIIGS crisis has dominated business news headlines and stock markets keep taking corrections every time there is mention of Greece. Let us first understand the basics of the common currency bloc

Euro-zone always had allied interests that allowed capital, people and goods to freely move within boundaries of Europe, more so after the Berlin wall collapse ending communist forces in the eastern bloc. With the exception of Germany, most countries were net importers of goods and services and a strong currency suited business interests. Also, the Asian Currency Crisis and 9/11 terrorist attacks much later, there were strong interests within Europe to create an alternative currency to the US Dollar. Germany being a high net exporter, also needed slightly weaker levels as compared to traditional marcs. So eminent politicians of Europe and banksters discussed next steps in this regard. Thus was born the concept of Euro - one continent one currency setup. Germany being the strongest member would have control of treasury for Euro. Certain rates were fixed for the Kroners, Guilders, Francs etc and all moved to common currency Euro.

Of course this had a short-term inflationary effect as salaries had to be revived by companies to match consumer spending in Euros. Things that were perhaps not adequately thought of during Euro creation

1] Diversity Mix in Countries: It is critical to note that Euro-zone has far more diversity in socio-economic conditions, similar to an emerging economy like China, India, Indonesia etc. The Nordic countries like Finland, Denmark, Sweden etc always were extremely strong economies due to low population and some strong industries. UK, France, Germany were also strong players in political as well as economic blocks. [The first alarm bell rang during creation itself - UK agreed to be part of Euro-zone geographically but not economically with the common currency] On the other hand, there were countries like Poland, Hungary, Czech Republic, Romania etc that had far more similarity with emerging nations than strong nations like Germany, Denmark etc.

It is no surprise therefore that even Indian technology companies like Infosys, Wipro, TCS set shop in emerging nations of Europe.

2] Disparate Policy Measures: The common currency setup implies control over Euro will be with ECB [read Germany] whilst fiscal measures are responsibilities of individual nations. Such a scenario never works. For details on this, please read the articles by Nadeem Walayat [] through the link given.

Look at India for instance - RBI and Finance meetings get log-jammed for this reason only. Everybody is pro-growth but anti-inflationary.  RBI has to do a tight ropewalk to take care of both. RBI chief rightly says within tools and powers in my arsenal, I can only control monetary policy. Fiscal prudence is government's responsibility and government after government is spending far more than earnings. [That is the reason why we have such a large and active bond market globally] The bonds are money raised from institutional investors to fund government expenses that cannot be covered with the tax collections. If we have this kind of a situation within India, imagine the state in a country like Spain, Greece, Italy etc

When the Euro started, it started to trade at parity with the USD. Over a period of time, it went from strength to strength. The going was good and everybody was in a mood to party. What nobody realized is challenges that will emerge over a period of time. Western society is very particular about welfare of human beings and there are a lot of provisions by governments in form of social security. So when the move to join a common currency came through, ideally there should have been as much harmony as possible towards fiscal measures as well.

Peripheral countries continued with their own schemes. Perpetual healthcare, high social security net for citizens etc. The music would stop at some point though. Over a period of time, countries started finding it difficult to meet even basic obligations to bond holders and that started sending jitters across the globe. [A large part of 2010-2012 equity correction was a result of this fear] Forget earning interests, recovering principal itself was a major issue. Institutional investors in bond markets are pre-dominantly banks themselves. That is when the bailout packages started coming in.

A Catch 22 situation started developing and is now reaching a crescendo; if ECB [i.e. German Tax Payers' money] keeps bailing out peripheral countries, it goes on a weak wicket back home. German citizens are angry. So when bailout packages are given to countries, they come with austerity measures. The moment there is austerity, public spending drops and creates political ripples internally in countries. Let me give 3 examples of countries based on my personal experience in those countries for considerable time for education as well as employment

Denmark: It had a strong corporate say with 3 major companies i.e. Maersk [large conglomerate with multiple interests though strongest in shipping related activities], Vestas [once upon a time king of wind energy] and Novozymes. The country has one of the strongest tax regimes but also some of the best social security measures. Due to exremely low population, it is able to manage all of that. Denmark is one of the countries where you literally don't pay anything for education. Rather, the government pays you to study and as long as you keep your grades respectable, you can study as much as you want in government recognized universities without bothering about fees. Hospital care is totally government responsibility - you only pay for the doctor's fees. If you are unemployed, you get allowance from the government [with certain conditions attached]

Maersk has been facing a tough time since the 2008 economic crash as shipping industry as a whole is still reeling under pressure. There is excess capacity of ships globally, ship-building once the pride of Denmark has shifted to Samsung, Hyundai in South Korea [Samsung is much more than mobile phones and consumer durables. Samsung has a very strong heavy engineering setup for ship-building, shipping containers manufacturing and Samsung accounts for almost 40% of South Korea's GDP!!!]

Vestas, once a crown jewel in the world of wind energy hardware manufacturing has lost out big to the Chinese. Since 2009-2010, the company has been tightening its belt to stay afloat. Novozyme is still active but being a bio-technology and pharmacy related company does not have too many employment opportunities. Maersk, Vestas and Novozyme put together probably employ over 50% of Denmark's population directly or indirectly [just like software in India. For every 100 jobs created by the It sector, it creates another 20-30 jobs in areas like transportation, food, telecom, facilities management etc] During good times, the housing market in Denmark was on a song with housing prices making new highs almost everyday. Now with bad economic times, housing prices have tumbled and the situation is so grave that the government has had to intervene and tell banks - increase tenure of loans to customers and forget the princpal - just focus on interest servicing!

Denmark or for that matter any of the Nordic countries like Norway [oil-rich], Sweden [home to Volvo, Scania and Ikea], Finland [home to Nokia-Microsoft] won't have much of a challenge. This is because of the countries' size, population and large businesses. In fact if the Euro zone breaks up and these countries go back to their old currencies 2 largest beneficiaries will be Vestas and Novozyme.

France: This country has been in a crisis since 1984 though they have never acknowledged it. It is one of the most populist and socialist governments that likes to control prices and keep high taxes. The population is ageing and state coffers are dry. They jumped on to the Euro with a strong currency in mind and let us not forget the country is a net importer of goods. The challenge is that austerity simply does not work in France. The work culture is different and if people are not happy, they can go on strike. In fact, France is plagued with strikes from bus operators to metro operators almost every month in some part of the country or the other. Tourism is a major attraction in France.

Spain: The people in Spain are very friendly in general and very relaxed as well in work culture. Lunch break can extend to 90 minutes as well. Spain is one of those peculiar countries where the paradox of socialist measures comes up to the surface. The average salary for simple jobs [factory workers, gas station attendants, security guards, tellers in supermarkets etc] is about EUR 1000 per month. Over 30% of the population under the age of 30 is unemployed. The government unemployment allowance is about EUR 800 per month [it varies from person to person but this is an average]. So a lot of youngsters are saying "Why should we slog out 160 hours a month for 1000 Euros salary when I can sit at home and make 800 Euros!!!" Classic Catch 22 situation for both Spanish and German governments. They want the Euro to be there as Germany is a net exporter and needs a market like Spain to stay afloat. For the Spanish government, laws for social security were made decades ago and taxes were collected in this premise. Now if the economy has to recover, you need youngsters to go out there and work. Unless the wheels of industry don't move, the government will be forever dependent on bail-outs.

Whatever is applicable for Spain, is applicable for Italy, Greece as well. It was once applicable to Portugal as well but they came back on their feet smartly. The premise that the Portuguese government used was a great sell to people; "Look I understand that your minimum wage has dropped more than 50% post-crisis. However, you also need to take into account that all other expenses you have to incur have also dropped significantly as the entire industry is reeling. Your net savings were negligible even in good times and even with a 50% reduction in salary, your lifestyle does not alter significantly" The masses took heart and started getting back to work - the end result is that a lot of firms found it productive to build manufacturing plants in Portugal. Transport within the Euro-zone is not much of a challenge. So taking into account carbon footprint, time to import from Asia etc, "total cost of purchase" for goods and services form Portugal are favorable to the industry.

Ireland also understood this concept well and hence the contagion has been arrested within reasonable means. Unfortunately as of now, Greece, Italy and Spain are having challenges with industrial rebound. Constitutional measures dictate that social security spend continue. Many youngsters not joining the workforce and smarter ones migrating to greener avenues like UK and US. The gap between what the countries earn and what they spend are significantly higher. Bailout packages call for austerity on these fronts but austerity comes with a lot of local backlash

What if the currency breaks up? Let us go back a couple of decades when we had the Asian Currency crisis that plagued Thailand, Indonesia, Malaysia etc. Initially there was panic, hyperinflation but what next? Thailand, Malaysia, Indonesia as tourist destinations that were once upon a time only for the wealthy people and business travellers came on the radar of common man. Exports from these countries started surging higher. They became highly competitive. Yes the initial 18-24 months after the crisis broke out was chaotic. That always happens with any economic crisis. But that does not mean the end of the world.

Greece, Italy, Spain etc all have strong olive production. They are excellent tourist locations. If the Euro currency breaks up and these countries go back to their original currencies, then tourism that is currently very expensive [due to Euro] will flourish. Today, just as it is common for an Asian to make at least one vacation to Thailand, Malaysia, Singapore etc, it will become very common to visit Spain, Greece and Italy in Asian currency denominations. Exports will flourish. As far as people are concerned, they just need to realize that rather than anchoring themselves with old salaries, numbers and denominations, they should focus on lifestyle. As long as they are able to get a certain kind of lifestyle [albeit a toned down version], it does not matter which currency they earn in and the amount.
But there is bound to be inertia as right from kindergarten, one has been conditioned with the notion that the state will take care of you.

There in lies the Catch 22 situation for Germany. They need the Euro [especially a weaker Euro] to stay competitive in industry. They have a captive market in Europe itself that will go away with the breakup of Euro-currency. The German Euro will move back to DMs and as against the prevailing Euro rates, the DMs will become twice their worth in exchange making them extremely noncompetitive. So they have a double whammy effect; lost customers as well as lost businesses. There is a vested interest on part of Germany to keep the Euro-zone intact for as long as possible. However, they face a backlash back home with tax payers who are slogging it out whilst peripheral countries are just enjoying life

So if any trade pundit says that there will be a catastrophe, it is fairly logical. When such fundamental changes occur, there is bound to be short-term negatives. That being said, it is not the end of the world. If anything, it is going to make things better from the current state of affairs. From an Indian perspective, today, a Europe tour package costs about 1 lakh INR per head for about 8 to 10 days. If the Euro-zone break up happens, that will bring down the bill by about 50%. Just as travel portals are wooing you for a budget trip to the Far East, suddenly you will be bombarded with advertisements to travel to peripheral Europe. 4 Day Spain visit for INR 27k, Greek island visit for 25k etc etc etc

And how do you make fund provisions for that? When [there is no question of IF - the Euro-currency collapse is inevitable] the contagion hits, there will be sharp falls in equities all over. Rather than succumb to fear seeing bloodbath on streets, at least in India we should look at building an equity portfolio. As I mentioned in my earlier post, the technical bottom for Nifty is about 7200-7400. In cases of extra-ordinary events like credit crisis, there may be short term pain perhaps even testing 5900-6200 levels. All that is nothing but great opportunities to increase portfolio holdings. Even if we go down to 5900 levels, the eventual target for Nifty is 10k [that will perhaps come in a couple of years] The fall to 5200 in Aug '13 was the sweetest spot to go long on equities. Likewise whenever the next catastrophe roils the markets, the entire 5900-7400 zone are sweet spots to buy. The purchases made in this period will translate to about 30% CAGR in a 36 month period.

To summarize - Euro-zone crisis is bound to roil markets globally. Either tax payers in Germany or people in peripheral countries will ensure that it happens [each for different reasons though] Despite all the austerity discussions, ECB will try its best to keep the Euro-zone intact for as long as possible for their own interests. When that happens, it is short-term pain but long term gain for everybody having stakes.

Waiting for that collapse to take place personally ;)

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