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€, A Crazy Currency Crisis

Wednesday November 17th 2010

It’s a long time since anyone could wholeheartedly sing, “When Irish eyes are smiling…” Smiles in Dublin have been in short order for sometime now.
Anyone who has read our work in the past will know that whilst not anti European, we are no fans of the Euro. However, there is a great deal of hype doing the rounds in the market at the moment. It is our belief that reasoned argument, not wild hysteria is called for. This matter, after all, will have resonant affects across the globe, not just the Euro Zone.
It is well understood that when a house is burning, the first issue is quenching the flame, not apportioning blame. However, in the issue of the Euro, there has been over the past decade, not just recent months a track record of short short-term cash infusions. These have done no more than create a pause in the path of spread widening. They are not, by any means serving as longer-term cures to sovereign solvency. 
The situation right now:
Let me consider the scenario that we have to deal with in the immediate time frame.
European finance ministers have started work on possible aid for the debt stricken banks in Ireland. This has stopped short of an immediate bailout package and risking a setback in bond markets.
In Wednesday morning trade one can see that Irish 10 year Government bond yield widened by 10 basis points (bps) to 8.50% placing the spread (or risk premium) over German 10 year Government paper at 5.70% or 570bps. This spread is wider by 8bps on the day. It is; however, lower than the peak spread seen on November 11th at 646bps.
 The cost of insuring against an Irish default has widened by 0.35% or 35bps to 554.5bps over 3 month Euribor. In a genuine blow to Ireland, LCH Clearnet Ltd hoisted the margin requirement for Irish bond trading to 30% of net positions, making it more expensive to buy Irish securities. If one feels at +570bps the Irish Gilts hold value, the potential payoff has been largely ripped away.
Take no heart from the fact that the Ministers of Finance in the Euro Zone are heaping praise on the budget cuts already put in place by the Irish. This is simple moral boosting rhetoric of the kind offered to Greece a month before a full blown rescue was required.
Why is no one grilling the ECB as why didn’t the summer stress test tell us more about the weak state of the Irish banks? They have no credible answer as the test was pitched at the lowest possible level to allow as many banks as possible to pass. Rather than a financial high jump it more akin to financial limbo. The Irish say they can go it alone and will not be asking for money when European and International Monetary Fund officials arrive in Dublin on the 18th to begin probing the banking system’s needs. That is a mistake as the need is great. The capitalization of Irish banks has fallen by 98% since the peak in February 2007!
It is no exaggeration to say that the integrity of the Euro is at stake. The currency is meant to be underpinned by the stability and growth pact. I have said before how Greece never met the requirements of the pact when it joined the Euro and now Ireland, after current measures to secure the banks is considered, Ireland has a debt to GDP ratio of 32%. The Stability and Growth pact sets a limit for this at 3%.
Forget all the polite smiles and happy handshakes. The hard truth is that members of the Euro Zone are struggling to show a united front. Pragmatists are pondering the issue of first Greece, next Ireland and then onto Portugal, Spain…maybe even Italy. The Iberian nations are eager to win the right to stage the FIFA World Cup in 2018. That would be a fillip to the economy as plenty of new build and refurbishment would be called for. MarketMind is in no punch pulling mood. If the Portuguese and Spanish get the nod for 2018; soon after they will be cap in hand for a financial bailout.
My nation, UK, has not covered itself in glory as in the past we have stood away from Euro Zone problems. However, in an act of blatant self serving interest, the Chancellor has indicated that the UK would back support for Ireland. A smart move maybe given that the UK and Irish banking systems have much interconnection. Of course we do not want UK banks to be infected by the Irish but this is a full act of self interest. No more can we point a finger across the channel at the French!
They of course always have an opinion and the Finance Minister, Christine Lagarde, said that if a small package to assist the Irish banks is insufficient, a full state aid package would be available in a few days. Another opportunity for the lady to remind how good French banks are.
Euro Zone politicians never give Euro issues their undivided attention …they always are testing the national mood and are ever mindful of the electoral cycle. In playing to the home crowd, German Chancellor, Angela Merkel has demanded a shift away from Germany funding the lion’s share of bailouts. She believes bondholders have to share the cost of future rescue packages.
Isn’t it brilliant when politicians get involved in the markets! Merkel’s comments led to a run of 13 days solid selling pressure in Irish Gilts and had a negative effect on the prices for the rest of the PIGS group.
Unbelievable as it is, Chancellor Merkel has gone further and indicated that she was in a mood to penalize bondholders for betting against fiscally unsound governments after the EU’s temporary rescue fund runs out in 2013. Will politicians never learn that the market is the only true indicator of value. Markets can be brutal but they are honest and an asset is only ever worth what another market participant is willing to pay for it. If an asset is mispriced why shouldn’t investors be free to openly trade from the short side?
As for  European Unity, forget it. On Monday, November 15th the Greek Finance Minister, George Papandreou accused the German leader of having created a “self fulfilling prophecy” that has simply harmed the Euro Zone periphery nations. Germany is not taking that line thought very readily and has accused Greece of being totally hypocritical as it has received vast amounts of both German and European support. The German Finance Minister, Wolfgang Schaeuble was quick to remind Athens that “…solidarity is not a one way street”.
Looking ahead…can a solution be found?
In order for the Euro project to work without a fiscal union, guarantees need to be set permanently in place. Moral hazard has to be eliminated and countries have to agree to work together even more closely than they are now or have done in the past. 
On the one hand, European integration seems more real than it has ever been. It is fair to claim that this has been partially driven by the financial ties the single currency has fostered. We are more inclined to heap greater praise on the freedom of trade and labour mobility. Still, making the single currency work in future without constant states of crisis solved by short-term panaceas on a case by case basis requires a much wider vision and sense of discipline. 
I have said before that Europe is best at arranging pointless summitry. It is just able to match the speed of decision taking that is seen in the US when it comes to financial matters.
f those that wish to punish the PIGS by banishing them from the single currency get their way it is the case that  past the exit door lays a return to dark, depressed economic era. Sovereign credit markets may well be closed to such nations and the bill for clearing up the mess will be borne by the strong survivors. The reality is that there is no such thing as an ‘orderly exit.
Since May, and the riots in Athens, we are not enjoying Europe’s finest hour. The lessons being learned are painful and riddled with anger, confusion and doubt.
The credibility of the Single Currency been dealt a serious blow, but this is not the fault of the Euro itself. Rather what is being reaped now is the crop of poorly planted seeds. Who on earth ever deemed it a good idea to allow into the club any nation that were not structurally ready to handle a single monetary policy. Let those nations get access to capital at an interest rate pitched at one quarter or a fifth of their legacy currency and it is like letting the fox into the henhouse. and declining government borrowing costs was a massive error. 
The take away lesson has to be that the structural adjustments, implementation of fiscal reforms and more closely coordinated fiscal policies that need to be accomplished are dealt with without delay. Problem is many across Europe see monetary union begetting fiscal union that in turn spawns political union. 
We do not see the Euro vanishing, but only core holding in Germany, Finland, France and Netherlands hold any intrinsic value. So much for the Euro being a counterweight to the Dollar. Investing in the rest is no more than passing a hot potato. Don’t hold it for too long lest ones fingers are burned.

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