To see why the Euro seems bound to fail, just look at the austerity measures being imposed on Greece. A collective fiscal tightening of 12.5% of GDP over three years means that Greece is unlikely to reach 2008 levels of nominal GDP until 2017 at the earliest (according to Standard and Poor’s). The medicine – deflation – might succeed, if it were not for the fact that this makes the country’s debt unmanageable.
Interest is accruing on Greek debt at a double digit rate all along the yield curve. Greece is well into debt trap dynamics, from which the only exit is likely to be a default and restructuring.
If Greece were an isolated incident, it might be argued that things could now settle down. Unfortunately, as recent market movements in other European sovereign debt markets show, the travails in Athens look like a harbinger of events to come elsewhere in the region.
A combined EU/IMF rescue package of €110 billion (if ratified in Germany and other European capitals) may be sufficient to remove immediate refinancing risk from Greece, by taking away the need to raise funds in the bond markets for the next three years.
However, shifting the debt burden from Greece to other Eurozone members merely raises refinancing risks elsewhere. Several people have pointed out the absurdity of Portugal (for example) having to borrow at higher rates than the interest on the rescue loan it is itself providing to the Greek government.
As a result, investors are now looking more broadly to see where the next blow-up is likely to occur. As the table below from Morgan Stanley’s interest rate strategy team shows, the absolute amount of bond market debt to be refinanced in Greece for the remainder of 2010, after a lumpy May, is relatively small.
The amounts to be refinanced in Italy, France and Germany are much higher. Paradoxically, while German bond yields have been pushed lower by a perceived “flight to quality”, it’s been in Germany that government bond auctions have already set a habit of failing. While federal finances in Germany look relatively under control by European standards, some municipalities are struggling to avoid bankruptcy, suggesting that the underlying fiscal position is as difficult in Germany as in many other developed countries. Italy and even France look like potential problems, given that both countries have to refinance debts approaching 20% of GDP between now and the end of the year.
Or look at Spain, already under market pressure and facing a single month of €31 billion of maturing debt in July this year.
Where the next pressure point appears is anyone’s guess – but it’s a very long shot indeed that there won’t be one.
The fact that Europe’s political elite has appeared completely unprepared for the current tensions, when combined with the lack of a defined exit mechanism from the Euro, surely increases the likelihood of a disorderly break-up. For the time being we have only expressions of outrage at the behaviour of bond and credit market speculators, or head-in-the-sand comments by the single currency’s supporters in the press to the effect that “the Euro exists, therefore it must succeed”.
Another research report from Morgan Stanley (“Lessons from Emerging Market Restructuring/Default”) reminds us that, by comparison with corporate credit restructurings, where there is now a set of well-established procedures, sovereign defaults are likely to be messy and chaotic. Investors should be on their guard.
For the Euro to have succeeded, a fiscal union should have been put in place to manage the inevitable tensions that arise when currencies are locked together. It wasn’t and – even worse – the entry criteria were clearly fudged to allow weaker countries to join. Those who suggest that a European Monetary Fund can now, at this late stage, be put together to bail out countries in difficulties are talking pie in the sky. The Euro is surely now well on the road to disintegration. The only question is how, when and where the breakup finally occurs.