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‘The market is made up of intelligent fools’ is a conclusion that I have arrived at after being in the hedge fund industry all these years.Fools because the participants follow a herd mentality and intelligent as it is not easy to bluff them.
We saw the ‘fool’ part last week when all the markets tanked on fears about US’s recovery prospects and Europe’s sovereign debt crisis.
In the next few weeks we are sure to see the market’s intelligent side at fore as it closely scrutinizes EU’s endeavours to rescue Italy.
If the former is unimpressed then the fools shall be back again with a sell-off, this time at a much larger scale. Does EU have a chance to prevent that? I give my 2 cents.
Italy is Europe’s fourth largest economy and has more than US$ 2 trillion in debt.
Going by the sizes of EU’s previous bailouts for Greece & Co. along with the growing discontent among EU peripherals (especially Germany), it is highly unlikely that Eurozone can put together a bailout sufficiently large enough to comfort the markets and rescue Italy (even though they have started buying Spanish and Italian bonds from the secondary market).
After seeing the downgrade of US’s credit rating, the core countries shall be very conscious of the threat to their own AAA ratings if they over-stretch in their commitment to the bailout. Lehman Brothers were considered ‘Too Big to Fail’; I feel that Italy can be aptly called ‘Too Big to Save’. If they go down like other failed peripheral economies, it would be reasonable to expect Spain will probably follow too, which would certainly trigger a chain reaction across the global financial markets. Along with markets deeply in red and rock bottom consumer sentiments, the financial Armageddon is almost certain to cause the breakup of the Euro.
So what are the options in front of European lawmakers (many of whom are surprisingly on vacation at this point in time) to send positive signals to a very jittery global market whose nerves have already been freckled to the limit by the debt issues and recovery concerns in US over the last few days ? I see only two ways (Warning: None of these are going to make German Chancellor Angela Merkel any happier)
- Breakup of the Euro: There are two Eurozones in European Union. The core countries led by Germany and France and the peripherals like Greece, Portugal, and Spain etc. The former are on various degrees of growth trajectories while the latter are in all sorts of fiscal mess with almost stagnant growth rates. Having their own currencies shall enable the peripheral nations to devalue their way out of trouble which is a luxury an appreciating Euro doesn’t allow them. The breakup of the Euro can be done in one of two ways: (i) Each country goes back to their own currency (Germany to Deutschemark, Italy to Lira etc.) or (ii) the core nations have one currency while the peripherals have another (say Euro 1 and Euro 2). Either ways, the ability to manage their currency in accordance with their economic metrics shall lead to growth of the currently stagnant EU member nations in the long run.
- Issuance of Eurobonds: A look at the spreads at which Spanish and Italian bonds are trading at the moment would show that unsustainably high borrowing costs these nations face if these countries go to the markets to raise more debt. At the same time, as I mentioned earlier, the EU can’t put together a bailout that can get Italy out of its troubles. Issuance of Eurobonds can solve both these problems. As an MBA student, the definition of Eurobond I learnt in my class was ‘A bond issued in a currency other than the currency of the country or market in which it is issued.’ Clearly this term came into existence before Eurozone got created. By Eurobonds here I mean – Euro denominated bonds issued by ECB and guaranteed by all the member nations (thereby spreading the credit risk around Eurozone). Due to the currency they are denominated in and the underling support from the member nations, the market is likely to react positively to them. In fact they might become the next ‘risk-free rate benchmark’ now that the US’s credit rating has been downgrading.
Needless to say, the core countries (especially Germany which has been firmly opposing this idea for a while now) shall not be happy and rightly so. It is like one guaranteeing her irresponsible and broke brother’s debts which shall not give him any incentive to mend his ways. The proposal is likely to spark and fierce political debate and public protest in the core nations and shall be a tough one to get a consensus on.
While I don’t rule out a breakup of the Euro before 2025, it would be a logistical nightmare and shall take EU members years to get things systematically on track. That is something these countries can ill afford at this point in time. More importantly the European lawmakers are too proud to admit that the creation of Eurozone based on geographical proximity of nations instead of their fiscal metrics was a BIG MISTAKE and shall not let the Euro break up until they are left with no other choice. Luckily for EU, they have a choice right now – Option No. 2, which would no doubt be tough to table but is their only way to go if they want to prevent a global meltdown and more importantly (from their standpoint), be around for the next few years.
This brings us to the obvious question – terms offered on the Eurobonds. Well an issuance of such massive size and offer terms (like multiple nations as guarantors) would be unprecedented in history and I might be completely off here. even more so because there shall be many subjective factors that have to be taken in account). Nevertheless I make a brave attempt.
Issuer: European Central Bank
Security: Guaranteed by EU sovereigns
Ranking: Senior Secured
Issue Ratings: AAA/AAA/Aaa (S&P/Fitch/Moody’s)
Issue Size: This number shall be a function of a lot of political and macroeconomic factors and can range from anywhere from EUR 100 billion to EU 200 billion (maybe even more).
Maturity: 2022 and 2042 (10 years and 30 years). I expect a short-term and a long-term bond to be issued together
Coupon: Around 4.75% for 10Y bond and around 6% for 30Y bonds (based on the AAA-rated Euro-denominated bonds issued by EU sovereigns)
Bookrunners: Top European banks
Key creditors: Everybody from Sovereign Wealth funds to Pension funds & Endowment funds to top banks of various countries to hedge funds to HNI clients of Private Banks shall be vying to get a piece of the offerings. China would probably sink its teeth into a major chunk as the country shall look to diversify its investments away from both the US and the dollar. Middle Eastern countries too shall try to stack up as much as they can using their petro dollars (through their SWFs) as they look to become ‘creditors of Europe’. For them this move would have more political and diplomatic significance than economic rationale. Needless to say that in such a high stakes game the book building by the bookrunners shall be extremely important which is why I expect top European Banks to be at the helm of this massive task.
In addition to bailing out struggling EU peripheral, the Eurobonds shall have the following positive effects for Eurozone:-
- The core countries won’t have to dig into their pockets to aid Europe’s sick children. This shall be good news for their fiscal balance sheets and consequently for their credit ratings.
- As the Eurobond shall be denominated in Euro, the currency shall experience sharp appreciation on issue subscription and can strongly put up its case for the position of global reserve currency in front of a world which is searching for an alternative to the US dollar.
However, if the peripheral EU countries aren’t able to implement strict fiscal measures and set their house in order, then this step won’t be of much help in the long term. These Eurobonds can buy EU time and prevent it from disintegrating in the short run, but it won’t be able to stop the inevitable if the peripherals don’t start pulling their weight before the end of this decade. Can they do that? I am not so sure but I hope they prove me wrong.
Tanuj Khosla is currently working as a Research Analyst at 3 Degrees Asset Management, a fund management firm in Singapore. He can be followed on Twitter @Tanuj_Khosla. Alternatively he can be reached at [email protected] Views expressed are personal.