Guest article written for AllAboutAlpha.com – the official publication of the Chartered Alternative Investment Analyst (CAIA) Association
In September 2011, the IMF estimated that roughly half of the Euro Zone’s $9 trillion in outstanding government debt was now at ‘heightened credit risk‘. This is a crisis which billionaire investor George Soros has described as, “…a more dangerous situation now than in 2008,” (which is further contextualised when you realise that Bank of England Governor, Mervyn King, described the 2008 crisis [on the record] as being, “…the most serious financial crisis we’ve seen at least since the 1930s, if not ever.”)
From small businesses to global banks and central bankers, there are few participants in the global financial market who are totally shielded from the Euro crisis. Even at ground level you will find 10.4% of the population of the 17 countries that use the single currency were, as at January 2012 out of work (over 16.5 million people).
To learn more about the Euro Zone crisis and what it means for the global economy, we spoke to Larry Hatheway (Chief Economist and Chief Strategist at UBS, a bank with [as at December 2011] over USD 2.2 trillion of invested assets). UBS are headquartered in Switzerland, and with over 65,000 employees globally are ranked as the second largest wealth manager in the world.
Q: Just how serious is the Euro Zone crisis?
[Larry Hatheway] This is a very serious issue that merits the very close attention of everyone involved be that Greece’s creditors, other official institutions, policy-makers throughout Europe and also market participants globally. Why? Failure to find some sort of solution in a co-ordination fashion runs serious risks of leading to a very disruptive set of economic and financial outcomes…. potentially every bit as bad as the financial crisis of 2008.
Q: Do you think a break-up of the Euro is likely?
[Larry Hatheway] I still think it’s unlikely, but I would have to say that while it was a very remote possibility a year or two ago… it’s less remote now. It still seems to be the risk-case rather than the central-case at the moment. A break-up of the monetary union is so potentially fraught with risk that all participants, whether individual countries like Greece, or the remaining Euro Zone members, would do their best to avoid it…
Q: In your view, what have been the key drivers behind the crisis?
[Larry Hatheway] It’s actually fairly complex, and hard to distil it down to a few words or root causes.
We can say, however, that the monetary union was flawed from inception. It included, under the framework of a single currency and a single monetary policy, countries that (sooner or later) were likely to have very divergent outcomes and therefore would prefer to see different exchange rates, interest rates, and monetary policy responses. This caused a lot of tension to emerge. In some cases, this [tension] occurred as a result of very poor fiscal policy making… Greece is surely one example of this. In other instances, divergences arose out of private sector decisions that produced serious outcomes- for example the housing and financial booms of Spain and Ireland…. juxtaposed against those that did not occur in countries like Germany.
The differences in competitiveness between countries… particularly those in the South such as Italy, Spain and Portugal who all became progressively less competitive within the Euro Zone… was also another source of tension leading to large imbalances in trade and current accounts between the countries of the Euro Zone.
It’s clearly not a single problem that has arisen to bring-about this European financial crisis… there are a variety of different routes to it which have all come to a head at the same time.
Q: Has there been a backdrop of declining growth or economic stagnation which has contributed to the crisis?
[Larry Hatheway] To the extent that the common issue that a lot of these countries face is large level of indebtedness in the public or private sector…. yes.
Dealing with indebtedness is done best in an environment of stronger growth and positive rates of inflation (they do not have to be high rates). The most difficult circumstance when you are trying to bring down budget deficits and a high level of indebtedness in the public and private sector? absence of growth and deflationary tendencies…. these will compound adjustments on debt side.
The single greatest deficit that Europe faces today is not a budget, current-account or trade deficit… but a growth one. With stronger growth, a lot of these problems would be quite a bit easier to handle, if not to resolve. It’s very difficult for Europe to generate that kind of growth at this moment in time.
Q: Do you feel policy and market interventions have been effective at stabilising the region?
[Larry Hatheway] I think there has been a part or mis-diagnosis which has taken place, particularly amongst the troika that put fiscal austerity at the top of their policy response. It was necessary in those countries that could no longer borrow in the international capital markets (Greece, Portugal and Ireland). It was clear that stresses and strains were also raising borrowing costs for Italy and Spain until just a few months ago. For those that were outside special programmes, they had to put in-place long-term credible fiscal adjustment programmes… there was no alternative… but they were long term. When you have high levels of indebtedness and big deficits… if you simply impose fiscal austerity, you may not be able to achieve your targets because GDP will begin to contract and that will place much greater pressures on the fiscal side of the equation.
Fiscal austerity is the primary focus of policy in terms of response. That is both a misdiagnosis and compounds the problem.
What Europe needs to do is also simultaneously embark on some strategies that would enhance growth. In some countries that is already underway. We see the Monti government in Italy has begun to focus on structural adjustment to allow the economy to grow. If these plans are effective, their economy will grow faster in the medium term, effectively raising productivity by unleashing some of the potential that’s there in labour and pension markets. Something like that is probably more necessary on a pan-European basis. From a growth and a political perspective, the elements of the programmes that have been put into place should also encompass guidelines which free up latitude for structural adjustment funds that would allow countries that would allow countries to see some benefit from official entities that would reward them for successfully undertaking and implementing policies.
Q: How do you feel policy measures in the crisis have impacted entrepreneurship?
[Larry Hatheway] I think in the short run (which means over the next couple of years) in countries, where austerity has been fully implemented, it will keep potential risk-taking activities, including entrepreneurship, at the sideline. This is for the simple reason that in those economies, growth is likely to suffer and anybody who would be thinking of starting or expanding a business would be concerned about the future unless they were in a very strong and cyclically protected sector. Sales growth in most sectors would be hit as demand is sapped out of the economy due to a combination of spending cuts and tax increases.
Over time… to the extent that policies are undertaken to promote a more liberal market with tools such as ‘portable pensions‘ for example… you may begin to see some entrepreneurial activity coming in to take advantage of changes in the market. You may also see the private sector coming in to provide some of the functions the public sector assumed. If we can see this through? there may be long-run opportunities.
For the time being, capital is probably going to stand back as there are too many uncertainties not least of which is the concern surrounding the lack of political will to see many of the implemented measures through to fruition.
Q: How can investors can defend their assets against the crisis, and are there any investment opportunities?
[Larry Hatheway] One of the challenges that government bond investors have had as they have watched the process unfold, is to understand whether they have much security or protection in the credit default swaps (CDS) on sovereign debt. If we recall last summer when the first proposals were put forward for ‘private sector involvement’ or a ‘voluntary restructure of Greek debt’ they were designed so as not to trigger CDS protection. That made a lot of holders, not only of Greek debt, but of Spanish, Italian, Portuguese and Irish debt increasingly nervous that what they previously thought was a legitimate instrument that they had acquired to protect them against incidence of default would… in fact… not do that.
As we’ve moved forward into the more recent stages of the Greek restructure, it now appears (by no means clearly) that it would include measures to trigger credit default swaps. For some in the markets, that is seen as a risk as it may imperil a counterparty that has underwritten too much CDS protection… but for most investors it will provide re-assurance that in a restructuring… those that did the prudent thing and took out CDS protection… will find that their asset is, in fact ‘money good‘. That will help stabilise some of the sovereign risk premiums in other peripheral government bond markets.
In terms of opportunities? I think some investors have begun to see that some policy responses- for example the ECB’s liquidity financing through the so-called ‘LTRO‘ programme- have tended to reduce the tail risk of events such as disorderly default spreading to the wider financial sector. On that basis, they have been rewarded if they were early to the game in catching some of the decline on risk premiums in the capital markets (including peripheral yields). Going forward, some of the stabilisation may cause other risks in the financial sector to recede which will open opportunities.
We are still in the early stages of trying to come to terms with the crisis and it feels a little too much like a risky environment than an opportunistic one.
What does this mean for investors and risk managers?
Hatheway’s views that the Euro crisis could be worse than 2008 are supported by many of his peers. In an interview for this site in September 2011, Jim O’Neill (Chairman, Goldman Sachs Asset Management) stated, “I think the biggest risk is the EMU….. I can see that this has the potential to derail the world economy in the same way the 2008 credit crisis did.” There are some realistic solutions to this crisis (which would not be difficult to implement) but any solution requires a great deal more political-will than the region seems willing to show. The crisis has also forced investors adn risk managers to reconsider the role of sovereign debt in their allocation models.
In a 2010 interview, Prof. Charles Wyplosz (Professor of the International Economics at the Graduate Institute of International Studies in Geneva, where he is Director of the International Centre of Money and Banking Studies) noted, “… The price to pay for having a common currency in Europe has been to do a half-baked job- in the sense that governments have not been, and are still not, willing to give up sovereignty in fiscal policy matters. Even before the Euro was launched, we all recognised that there were weaknesses built in the European construction, and that if these were not attended to, they could turn out to be a big problem. And here we are today! The fiscal indiscipline in a number of countries has created the current debt crisis, and we will have to draw lessons and create solutions to prevent it happen again. While I am not surprised at the debt crisis itself, I am surprised at the political reactions and policy mistakes which have been made over the past few months which have given the Euro area a bad name around the world.”
In itself, this crisis has not come as a surprise to investors or risk-managers. The size of it, however, has grown beyond most observers expectations… and the situation is still unfolding.