The Ongoing Euro Saga, Where Will It Take Us?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

Europe is complex because it is comprised of 17 different countries. This might seem obvious, though begs the question why the European Union expects the rest of the world to view it as anything other than 17 different countries even if they do share one currency. In this slow motion fiasco that has been played out since March, the idea that Eurobonds could be used to fund euro zone sovereign debt was floated and very quickly thrown out by Germany. After all, why should it pay the higher yields such bonds would have over German bunds? On Monday, November 7, the EU tried to sell the European Financial Stability Facility (EFSF) bonds maturing February 2022. It was only a try because the EU sold 3 billion euros, but had to price them more than one percent above the benchmark swap rate compared to the 17 basis point premium it paid at the last auction on June 15. The EFSF auction had been from the prior week as the Greek meltdown was in full swing. It is thought the EU wanted to sell EUR 5 billion, which would have been a game changer, indicative of what could lie ahead for the euro zone sovereign debt bailout program.

Talk is surfacing that a decoupling of the European situation is starting to occur from the rest of the global economy. The world really turned upside down when at the G20 meeting the BRIC countries (Brazil, Russia, India, and China) considered putting money into the IMF to help fund the European bailout. Europe has on average a slight balance of payment (trade) surplus and its population has far less personal debt than the U.S. Italy also normally has a budget surplus and a very viable economy, which it has used to raise its debt levels. Under normal circumstances, Italy has navigated the tightrope of high debt levels with these other offsetting factors - a very different story from Greece. Another example is Japan which has a debt-to-GDP level of 200 percent, higher than any other developed country. Yet the country is in times of high risk aversion considered a safe haven for money. The reason is that Japan consistently has a large trade surplus that gives them the liquidity to run high debt levels, with very low interest rates and little consequence (besides nearly 20 years of deflation).

The problem for Europe is that the funds are spread between the different economies in the euro zone, based on the performance of the individual economies, and not where they need to be. No surprise that Germany has the biggest surplus of funds and the PIIGS have the biggest net deficits. If you add together the budget and trade balances, they net out at a slight deficit due to the rising funding cost on the debt of the PIIGS. Germany is not going to, and should not in my opinion, be expected to use its good credit or funds to prop up the cash appetite of the PIIGS. France and Germany and other smaller EU countries either had the funds, or borrowed at lower interest rates and lent those funds to the PIIGS receiving the higher interest rate yield from those sovereign bonds. Think of it as almost a carry trade without the currency exposure. As such, the French and German banks funded the PIIGS and are now losing money on those trades as the risk of default increases. Since the credit crunch of 2008 this funding all but slowed to a halt, creating the situation we are now experiencing. This brings us to the present. With the European countries borrowing and lending to each other up the pyramid of the European yields, the system has become unmanageable and like all Ponzi schemes when the money stops flowing in, the whole structure breaks down.

When this scenario plays out as it is at the moment, the debtors have to balance the books and the surplus countries have to negotiate to fund them at what they find acceptable terms. The trouble is there does not seem to be that accord. The austerity measures have broken out in violent demonstrations in Greece and cost its leader Papandreou his job, for now, and are all to no avail as the budget cuts still do not balance the budget. Greece cannot pay back any debt until it starts earning money, like an unemployed person who cannot pay off a credit card.

The talk of leveraging the ESFS fund up to a trillion euros will only work if Italy does not get brought down. If this should happen then it will not be enough. That aside, Europe and most other countries in this position got here by leveraging themselves into the current debt levels and here Europe is saying it will employ leverage - which caused the problem - to resolve the problem. As the saying goes, only a fool makes the same mistake twice.

The point I am trying to make is that the problem is not solvable without breaking up at least some of the euro structure due to the lack of ability to devalue the individual currencies. Please review the article I wrote on January 4, "Will the Euro Survive?" The pressures within the EU and euro structure are probably insurmountable. In 1999, the renowned Nobel Prize winning economist, the late Milton Friedman, said "It seems to me that Europe, especially with the addition of more countries is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart."

A Solution? 

At the end of last week it was reported German policy makers were discussing how some countries could step away from the euro in an orderly exit. There are many ways Europe could change structure. A north-south split with the PIIGS (Portugal, Ireland, Italy, Greece and Spain) forming a euro south (B) and the other countries would remain in the current euro north (A). This would avoid going back to the legacy currencies and both sections would be able to issue debt at different interest rates, which is what the financial markets have effectively been dictating to them anyway. A simple system of differentiating the notes of the north and south could be devised. Print a large B on the southern notes and an A on the northern notes. Both would have their own exchange rates with that of the PIIGS, the B euro, suffering a large devaluation at inception, while the A euro would remain and strengthen against the dollar and other currencies reflecting the split from the worse debtor countries. As the southern states get their houses in order they could - to use a soccer analogy - be promoted from the second division back to first division. The objective: to get the whole euro back together after countries get their economies in order.

What the Future may Hold 

Greece is still a problem as it cannot pay back its debt no matter what happens. The deputy shadow economic minister said last week Greece would have to be forgiven all of its debt, not the 50 percent or 60 percent haircut on the debt swaps that was discussed recently as they just do not have the earning capability, regardless what austerity cuts are put in place, to make the money enabling them to repay the debt. The conclusion appears to be that Greece needs to leave the euro zone. It has also been suggested it could remain part of the European Union without being part of the euro the same way the UK, Denmark and Sweden are now.

There are many other possibilities, with the market talking today about pressure mounting on France and Belgium due to bank exposures and the Spanish 10-year yield rising over 6 percent for the first time. If the political pressures mounted inside Germany, despite German Chancellor Angela Markel's hopes, Germany could pull out of the euro and leave the rest in place.

The Coming European Recession 

Whatever happens, European growth will slow and decline into a potentially long recession, which will act as a break on global growth and undermine the euro. A Chinese official commented during the G20 meeting last week that Europe suffers from indolence and sloth. One would think if this is a general perception, then China would buy less European debt. The roll-on effect of a slowing Europe would also mean European demand for Chinese goods would slow and so would China's need to buy more euros to balance out its currency reserves. This strategy of balancing its currency reserves so it reflects the amount of trade it does in different countries currencies makes a lot of sense and seems to have been the driving force behind the Chinese buying euros in the last couple of years. Europe is China's leading trade partner, not the U.S. Yet in the past the U.S. dollar was by far the largest currency in the foreign currency reserves.

As I said in January, I doubt the euro will exist in its current form, even if only Greece has to exit, but it appears to have now gone beyond that point. The market has European debt in its sights and has the ability of forcing Europe to restructure. If it does not speed up the process the market is likely to force the outcome. It is highly unlikely the euro will maintain the trading range it has been in for the last year with a floor of 1.2850.