What do Mexico, Greece and Dubai have in common besides warm weather? DEBT — mountains of it. And where there's smoke, there's fire.
The real concern in the markets is who might be next. So far we've had a solid USD risk aversion run (along with a more than healthy bit of EUR, GBP and AUD profit taking as well) in response to the latest Greek downgrade. However, does that mean another round of USD gains? If so, that is NOT good for the markets as, again, this would be similar to September 2008 when the financial world as we knew it blew up and everyone ran for cover because of systemic risk. A rapid short-term rise in the USD based on some sense of sovereign risk should be considered quite a market destructive event, as I believe it would portend something not really seen since the 1997 Asian currency debacle — regional systemic risk. Except at the center of this one is the eurozone leadership, predominantly the ECB and Brussels, as they will be highly scrutinized to see how they avoid a crisis. Perhaps the next bellweathers are Ireland, Spain, Portugal and South Africa to set the stage for further danger or a peaceful end to worries about sovereign risk. Perhaps there are now more urgent discussions around regional common currency unions to combat sovereign risk with regional collateral.
First, the Greek situation and implications for the eurozone political framework. The Greek government must tackle a fiscal deficit of 12 percent of GDP, which prompted a recent ratings downgrade by Fitch and obligated Prime Minister Papandreou to stand up earlier this week and announce "bold" measures to bring the shortfall back down to 3 percent by the end of 2013. Right. The market has not been particularly impressed. The EURUSD fell from a high of 1.5062 rapidly dropping to 1.46 and now trading at 1.4290. The 10-year yield spread of Greek government bonds over bunds, now standing at 241 bps, is up from 207 bps just prior to Mr. Papandreou's speech and 105 bps just four months ago. Rightly or wrongly, the market was seemingly unimpressed with the government's failure to match the draconian public-sector wage cuts of 5-15 percent implemented by Ireland. While Mr. Papandreou's proposals appear far-reaching, nonetheless, implementation is another matter with the civil servants' union Adedy already having announced its intention of resisting any attempts to cut wages or pensions.
Whether or not a debt crisis can be avoided in Greece remains to be seen, but the whole affair has once more raised questions about the political and structural mechanisms of the zone (following Latvia's own crisis earlier in the year). Are eurozone states ultimately obliged to come to the rescue of a profligate member and realize the moral hazard that the stability criteria are designed to avert? If not, would they decline to intervene with a larger member country, maybe Poland, Ireland or Spain? Uncertainty in this regard stems from the fact that officials cannot endorse any other scenario than one that results in deficit reduction — all of which makes "assurances" from senior officials ring hollow. For example, Economic and Monetary Affairs Commissioner Joaquin Almunia said last week that Greece's problems were a matter of common concern for the EUR area as a whole. However, Mr. Almunia also said on Sunday that "if Greece does not take the necessary measures to overcome its problems, the eurozone won't be able to take them in the name of Greece." Not very reassuring words.
Let's add to it the problems in Dubai. Again, the specter of a sovereign nation not being able to solve its debt problems on its own puts the larger region and subsequent political and financial infrastructures in question and risk. Does that mean financial institutions create new strands and requirements of regional collateral versus simply working with a particular country or does it mean more common currency unions? Will there be a GCC (Gulf Cooperation Currency) for the Middle East? A new CNI (Chinese rupee?)? A SAQ (South American quetzal?)
In view of the current plight of Ireland and Greece, whose governments must perform an act of escapology from a looming debt crisis with the onerous constraint of an inflexible Euro, you might imagine that currency unions are not particularly in vogue right now. However, when a number of small economies are dominated by a homogenous industry whose principal product is priced in the same currency, then the benefits are a little clearer to see.
So it was that Kuwaiti finance minister, Mustapha al-Shamali, announced at the conclusion of a two-day meeting of the Gulf Cooperation Council that agreement for a Gulf Arab monetary union had been enacted. He said that "the GCC will now define a calendar for the institution of a central bank before reaching the objective of a common currency." Although this is an important landmark in a process that has been in the works since 2001, there is still some way to go before the project is concluded.
Having thrown plans for monetary union into turmoil when it de-pegged from the USD in 2007 to fight inflation, Kuwait's unambiguous backing for the project — as rotating president of the GCC — is not without significance. However, this does not mean to say that hurdles can be overcome with any greater haste. Kuwait Foreign Minister Sheikh Mohammad al-Salem al-Sabah has informed parliament that, "Issuing the (Gulf) currency … will take a long time and could reach up to 10 years." And perhaps some hesitancy on the government's part could be gleaned from the fact that Kuwaiti lawmakers demanded another vote on the issue ahead of the GCC decision. It probably has more to do with the fact that Oman and UAE are not part of the GCC plan. Until then, one could expect China to lend support to the GCC in the absence of those two until such time they no longer can avoid this issue due to Chinese demand for oil.
The implication is that sovereign risk has rapidly morphed into regional risk, analogous to the origins of WWI, and with it political structures that embrace non-sovereign mandates. For financial institutions, their worlds have gotten more complicated in terms of collateral, but in the end, wherever there is any money left is where they will pursue payment. For corporations, there are new and more immediate problems.
There is a business answer and a currency one. First, like all business risk, diversify to the extent you can to mitigate risk. Unfortunately that is a luxury most of our clients are unlikely to have. As foreign exchange advisors, that discrete level of currency protection against systemic risk reactions, such as debt downgrades, can be gained by first looking at your functional currency. If you are selling or operating in Greece, you may seem relatively safe with the EUR or do your competitors really have functional currencies in Eastern Europe, Taiwan, India, Brazil, and Guatemala, and do you need to be concerned about it? Yes! What happens if Spain's credit, and or perception of it, is impaired? Ireland? Italy? Does the Greek risk outweigh the EUR risk?
That is the foundation of strategy we need to address. We'll use the proverbial adage: if you define a problem as a nail, a hammer is the only solution you will use. The problem is that you might really be building a garden and what good does a nail do other than puncture the seeds of growth you are seeking? Building a currency strategy that includes an analysis of functional currency as well as transaction and translation exposure management for international clients is a must. It allows for companies to use basic FX tools such as spot, forwards, swaps and options to build what may seem like complicated but very useful things like basket currency hedges and sophisticated multi-currency options strategies as well as better international cash management, credit and treasury programs to deal with sovereign risk. Or, as we argue above, that single country risk is instantly attached to its larger geographic region and brings into focus whether a single currency hedge is a sufficient strategy any longer in our very interconnected world.
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