Day 340-2011 : Coming soon...Eurogeddon?

It has been on the slow boil for some time and there is every possibility now, that it might just boil over.  The failure of the politicians in Europe combined with the toothless actions of the European Central Bank has ensured that we are probably very close to witnessing the death of the unified currency, Euro.  There are however many who still believe that it is simply inconceivable that the Euro might break up, mostly politicians and their side-kicks.  Must I remind that the sovereign debt crisis which is at the root of this existential question for the Euro, has already resulted in a few governments being evicted.  It is certainly time to seriously take a look at what went wrong and what are the options now. 

What went wrong?

One size cannot fit all.  One currency with 17 different economies, the fundamentals of every economy being different due to the unique mix of resources that they have.  The fiscal and the monetary policies, which drive the management of these resources towards continuous growth and development also did not have any commonality even after the single currency came into effect at the turn of the century.  The stronger core countries like Germany and France used the compromised parameters of the new currency to push their exports contributing to actual GDP growth.  The other peripherals, namely Greece, Ireland, Spain, etc. bungled fiscally under the false impression of a strong currency and overspent to put themselves on the same growth path as others in the union.  The result:  Huge globs of sovereign debt, which these countries are finding increasingly difficult to service.  The expectation is that the stronger (and richer) countries help pay off the debt of the weaker ones.  However, the baker in Frankfurt will now ask his government as to why should he pay for the sins of his 'European' colleague in Athens.  At least the governments of the stronger countries fear so.  Quite justifiably so.

What are the options?

Businesses world-wide are already making contingency plans and running stress tests on the various possible scenarios.  So what are the options?  There are numerous permutations possible, however, broadly, there are three:

1) A Partial Breakup:  It is widely speculated that this is the most likely scenario which might play out.  The withdrawal or expulsion of the peripheral, weaker countries like Greece, Ireland, Portugal and Spain from the unified currency.  For the stronger countries and the advocates of the continued unified currency, this might be their best option.  It will however have severe consequences.  The change will have to be controlled, failing which this can snowball into a free for all.  The weaker countries do not have a choice.  They will have to implement severely restrictive austerity measures if they have to continue in the union.  They will also have to brace for a severe devaluation of their new currency if they pull-out of the union.  It is a choice between the devil and the deep sea.  There is the probability of returning to long term sustainable growth, however, to get there these countries will have to make innumerable sacrifices and prepare for the worst, including a run on the entire banking system of the country.

2) Full Euro Breakup:  The full blow-up could have major consequences across the globe.  It is very obvious that any exposure (by means of a financial or non-financial contract) to the Euro will mean instant impact.  The failure of one of the major currencies in the financial markets most certainly will have a domino effect on all asset classes.  EU is a major export market for the US as well as many emerging Asian economies like India, Thailand and China.  The denomination of the Euro into 17 different new currencies will bring with it the currency risk of severe devaluation / revaluation.  This is apart from the logistical challenge of creating (printing, valuing & distributing) a new currency overnight; remember, the member countries had almost a decade to plan for the common unified currency.  Clearly, this is the worst case scenario, and it will take down more than the European Union countries with it.  Major economies across the world will feel the pinch and may even be driven into a prolonged recession.

3) Do Nothing; Maintain Status Quo:  This is what has happened till date.  We are living this scenario right now, thanks to the prolonged procrastination of the leaders of the European countries.  However, this scenario is clearly not sustainable.  The idea of robbing Paul to pay Peter is not sound economics.

Whatever be the outcome of the unique situation that the world finds itself in today, there will be plenty to learn from Europe's expensive experiment with a unified currency.  The Afro....and the Asio (?!?), beware!

Take care!

Day 191-2011 : Investors On Strike!?

This was how an extremely articulate business leader described the current state of global financial markets a couple of weeks ago.  The BSE Sensex has fallen to a little less than 18900 from the highs of around 21000 six months ago!  This downward trend is seen in other major markets in the world.  Gold prices have appreciated exponentially and crude is again closing in on the $100 mark.  Countries in Europe are struggling to stay afloat.  Greece almost defaulted.

So what is happening?  The answer is:  Exactly what was happening a year ago!  The PIIGS (the group of European countries namely Portugal, Ireland, Italy, Greece & Spain) were in trouble exactly a year ago, when they were about to run out of cash and the IMF and some of the other eurozone countries bailed them out.  These countries are again out on the streets with the begging bowl...at least Greece is, and I am assuming Portugal will soon follow.  The austerity measures and structural reforms agreed by these very countries have not worked and have in fact been huge flops.  Instead of uniting the entire country in these times of crisis, the austerity measures have been a subject for heated debate and, specifically in Greece, public unrest.  Pro-austerity pundits believe the policy makers have not gone far enough for them to work, and the other side of the argument is that the austerity measures have in fact worsened the sovereign credit crisis.

The future of Euro as a currency is in question again as it is very clear that the inability of these countries to control their currency is one of the reasons for the crisis.  The United Kingdom, though impacted by the latest crisis, must be standing in the sidelines with a smirk on its face.  The fact that it did not join the Euro, is seen as the prime reason that it is not in a bad shape compared to others like Ireland.

Interestingly, everyone fears that the response of the market participants to the latest crisis is going to be very similar to that of 2008.  Everyone tries to de-risk, hold tight and clams up, thus causing liquidity issues in the financial system.  Investors on strike!  The declining volume trends of trades executed in the exchange-traded as well as the OTC markets over the last few weeks are very good indicators of what is in store next.  Is it going to be 2008 revisited?  A couple of key indicators are definitely different this time compared to 2008.  Unemployment rates as well as the level of public debt of major world economies, are both higher this time, thus reducing the ability of the global economy to absorb systemic shocks like a sovereign debt default or a banking system collapse. 

Hence, my view is that the world at large cannot afford a policy mistake like the Lehman bankruptcy this time around.  Sovereign policy makers as well as key corporate functionaries in today's interconnected financial system, will need to respond in a co-ordinated manner, to understand and control this emerging challenge.  There is far too much at stake...as everyone knows. 

Take care!