Understanding The Latest Eurozone Worries


This commentary was written by Bill Witherell, Cumberland’s Chief Global Economist.  He joined Cumberland after years of experience at the OECD in Paris.  His bio is found on Cumberland’s home page. He can be reached at [email protected].

Earlier this year it appeared that economic and financial policy officials were finally coming together with an effective approach to addressing the critical debt crisis in the smaller “peripheral” economies of the Eurozone — Greece, Ireland, Portugal — and ring-fencing the other Eurozone economies, particularly Spain, Italy, and Belgium, from the risks of contagion. Recent events, however, have led to a renewed sense of crisis in Europe that is having a depressing effect on investment sentiment around the globe.

The latest cause for worry, as we write, is the warning by Standard & Poors that Italy’s sovereign debt rating of A+ is at risk (a one-in-three chance) of being downgraded in the next 2 years, due to doubts about the success of the government’s debt-reduction program. Important concerns are the weakness of the Italian economy, which advanced only 0.1% in the first quarter, and questions about the political commitment to needed productivity-enhancing reforms. The Italian Treasury countered with a statement that it will intensify
structural reforms and efforts to balance the budget. Italy has the third-largest economy in the Eurozone, following Germany and France.

There are also worrisome developments in Spain, the fourth-largest Eurozone economy. The Spanish government has been noteworthy in its pursuit of well-directed actions to address Spain’s debt and banking-system problems, and the Spanish public has demonstrated an understanding of the need for austerity and reform measures. The current weakness in the Spanish economy, which seems likely to continue for some time, may weaken this resolve. Another concern is the results of last weekend’s regional elections, the worst showing in 30 years for Spain’s ruling party, and the risk that this will lead to the discovery of higher debts accumulating on the part of Spain’s municipalities.  An encouraging development Monday was the
market’s reception of Spain’s 3.2 billion-euro sale of 3-month and 6-month treasury bills.

While concerns about developments in the large economies of Italy and Spain have contributed to the unease in financial markets, both of these countries are likely to be able to avoid any call on the European Union for financial assistance.  Instead, our greatest worries relate to the very small economy, Greece. Fitch downgraded Greece’s long-term debt to B+, four notches below investment grade. Greece is clearly falling behind on its austerity and reform commitments and has to come up with a revised and more far-reaching action program. This was predictable.

What were less predictable and more worrying are the emerging difficulties at the policy-making level in Europe. The cohesiveness among the member nations of the Eurozone, among the wider membership
of the European Union, and among officials of the EU, the European Central Bank (ECB), and the IMF that appeared to be emerging in the early months of this year has not been evident in recent weeks. Probably some of the dissonant noise and rhetoric should be expected as officials struggle with very difficult decisions. Yet there appears to be a growing risk of policy paralysis, with European politicians voicing positions that are strongly and publicly opposed by Europe’s central bankers. This is our greatest worry.

On one side there are the European political figures that have been suggesting some form of debt restructuring for Greece. The chairman of the 17-country Eurogroup, Jean-Claude Junker, suggested that Greece may have to have a “soft restructuring” in the form of a “reprofiling” of the debt. The ECB strongly opposed such suggestions, indicating any such action would destabilize the euro and the banking system.  ECB President Trichet is reported to have walked out of a meeting with Junker.  Extending the maturities of Greek bonds “would make it impossible to accept them as collateral for refinancing operations under existing rules,” said Jens Weidermann, Germany’s new Bundesbank president.  Greek banks would be cut off from the provision of liquidity by the ECB.  Juergen Stark, an ECB Executive Board member,
pointed out that any kind of debt restructuring would counter efforts for Greece’s return to the bond markets and weaken reform efforts. France’s Christian Noyer joined the ECB chorus, stating that a restructuring of Greece’s debt would be “a horror story” that would leave the country out of financing for years.

The ECB is stressing that what is needed now is more determined action by Greece.  The IMF warns that “… if we do not accelerate structural reform, the deficit will get entrenched where it is now – about 10%
(of GDP).”  Another ECB board member, Bini Smaghi of the Bank of Italy, warned politicians against “using meaningless phrases.” In my previous position at the OECD, I came to respect Bini Smaghi’s clear
thinking and speaking when he chaired OECD’s Financial Markets Committee. Last week he commented that Greece should “convince its citizens to pay taxes” and to “retire at 65 as everyone else does in the western world.”

Papandreou’s government has to come up with a convincing revised fiscal plan this week. Satisfying the demands of the European Union while faced with opposition to increased austerity on the part of a
majority of Greek citizens will be extremely difficult. This was evident in the immediate political opposition to the Greek government’s endorsement of an accelerated asset sales plan. The government intends to sell its stakes in Hellenic Telecommunications organisation, Public Power Corporation, Hellenic Postbank, and the country’s ports. These privatization moves are in line with the strong urging of the IMF.

If, as we hope will be the case, the warnings of the ECB are heeded, the Europeans will need to assist Greece in funding its 2012 needs, as Greece is unlikely to be able to raise the required amount from private lenders. A decision on this will likely be taken next month, after intensive haggling. If policy paralysis does prevent this, or if some form of debt restructuring is agreed, we share the ECB’s fears
about the effects on markets.

This renewed crisis in the Eurozone comes at a time when the European economies appear to be slowing down after a strong first quarter, and despite this, policy interest rate increases by the ECB are expected in the coming months. There are other headwinds affecting the global markets: somewhat slower growth in China, declining commodity markets, the uncertainties surrounding the coming end of QE2, and more restrictive fiscal policies in many countries.

We have moved Cumberland’s portfolios into a more defensive stance. With respect to Europe, we have pulled back from Spain and Italy and are maintaining positions in just the strongest European markets:
Germany, France, Netherlands, Sweden, and Switzerland.  The year-to-date (as of May 23) returns for the German ETF, iShares MSCI Germany (EWG), and the French ETF, iShares MSCI France (EWQ), are + 7.48% and + 8.79% , respectively, substantially outperforming the +1.48% return of the benchmark iShares EAFE (EFA).