Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 25 April 2012

Eurozone: The Argument For


On occasion I like to construct scenarios at variance with my investment base case. It dispels confirmatory bias by forcing me to examine all evidence and arguments on the issue. The latest bout has been sparked off by discussions with people who are decidedly more sanguine on the Eurozone than I am. So I thought that I’d construct a scenario where the Eurozone emerges victorious from this battle for its survival. (The battle has the makings of a great movie: Paulson and the evil speculators vs Knights Templeton, El-Erian and the Real Money Gang) 

Here goes:

Rejection of Germanic austerity is gaining ground in Europe as erstwhile secure citadels like Netherlands fall. Along with the withdrawal of support in Holland, the support for Hollande raises the probability that descent into a debt-deflationary spiral may be avoided. Italy and Spain have already unilaterally raised deficit targets and other peripherals are unlikely to hit theirs. From a growth perspective, this is good news. But it is not enough. Even now, austerity remains the dominant theme and talk of fiscal expansion is timid at best. At a time when the private sector is de-leveraging, unwilling or unable to expand, the government has to step in to prevent a debt-deflationary collapse. Rejecting Keynes based on selective reading makes for poor policy alternatives.

Unfortunately it is almost impossible to undertake bold fiscal expansion given current levels of indebtedness and shaky investor confidence. The market allows European nations to have any fiscal policy they like as long as it’s austere. Despite this, there is cause for optimism. It comes from the unlikely direction of the ECB. Like the Fed and BoE, it has sounded more hawkish than it has acted. At every point in the crisis, it has gone against Bundesbank principles to buy more time through SMP, LTROs and collateral widening. Greece shows that an insolvent government can still finance itself through a pliant central bank. In the case of Greece it was not allowed to be taken to its logical end because Greece is an exception (one hopes that no other member manipulated data to quite the same extent in order to join and stay in the monetary union). The Greek trick involves issuing T-bills which investors finance through central bank borrowing. Government borrowing is easy as long as domestic banks are willing to indulge in this ECB financed carry trade. Therefore if the Europeans decide on fiscal expansion and the foreigners take fright, all they need to do is engage in monetary financing through T-bill issuance. At some point even the foreigners will want a cut of the free money (Russian default demonstrated that where free money is concerned, investor nationality is no bar)

Of course, structural reform will still be required to eventually break free from the short-term monetary financing cycle. The good news is that indirect monetary financing provides a long enough timeframe for structural reforms to take effect. The better news, for those who believe that CDS is the instrument of the devil, is that it would destroy CDS buyers. Loyal bondholders may suffer through currency depreciation but that is the price for keeping the union intact.

The two problems with monetary financing are that first, German resistance is sure to be encountered. And second, indebted governments are very likely to relapse and abandon any reform. There are grounds for optimism on the first as TARGET2 imbalances increase and ECB balance sheet carries more and more credit risk. The Germans will realise that the choice is between compromising their cherished ideals or participating in mutually assured financial destruction.

There is less hope of resolving the second problem. Italian backtracking on labour reforms shows that corrective action is not guaranteed even with market pressure and an unelected technocratic prime minister. If promises of reform are not credible, and they are not at the moment, Germany will be unwilling to compromise. However, it is only a matter of creating the right incentive structure. Quotas for monetary financing can be agreed in advance with the promise that those who successfully undertake structural reforms join a fiscal union. Those who fail will be left on their own to be eviscerated by the market. Since the impact of most structural reforms is felt within one/two election cycles, the threat will concentrate the minds of even the most populist politicians.

The LTROs have provided enough time for the Eurozone to come up with the correct medicine to save itself. Structural reforms, however hesitant, are taking place even as events are forcing it to abandon misguided austerity. Therefore reports of its demise are grossly exaggerated.

If one believes that the above scenario will come to pass then the trading calls are:
1. Sell CDS/Buy bonds on Spain and Italy
2. Buy curve steepeners on Spain and Italy
3. Buy Spain/Italy/Ireland/France/Belgium/Netherlands/Austria vs Germany
4. Bank-sovereign spread convergence (for TBTF and nationally important banks)
5. Sell EUR vs USD and vs GBP
6. Buy short-end T-bills for peripherals

No comments:

Post a Comment