The End Of The Euro: A Survivor’s Guide

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

In every economic crisis there comes a moment of clarity. In Europe soon, millions of people will wake up to realize that the euro-as-we-know-it is gone. The economic consequences of a failed system await them.

This is the thesis outlined by Peter Boone and Simon Johnson in their recent Baseline Scenario blog dated May 28^th.  It is also a classic failure of risk management and its failure to correct initial flaws in the creation of the euro.

Europe’s crisis to date is a series of “decisive” turning points that have been nothing but another step down a steep hill.  Currently, Greece has faced five years of recession, over 20 percent unemployment, a series of broken promises from politicians and EU bureaucrats, resulting in political backlash.  Greece’s economy can only get worse.  

Some European politicians are now telling us that an orderly euro zone exit for Greece is feasible under current conditions, and Greece will be the only nation that leaves. They are wrong. Greece’s exit is simply another step in a chain of events that leads towards a chaotic dissolution of the euro zone

During the next stage of the crisis, Europe’s taxpayers will be rudely awakened to the large financial risks that have been foisted upon them in failed attempts to keep the single currency alive.  The cost to taxpayers if Greece quits the euro could easily reach euro 300 billion.  However, the ECB has taken the view that it has not taken any excessive risk.

A likely scenario is that the ECB realizes it has taken on a large amount of credit risk on its books.  Investors start to flee peripheral banks and ECB funds fail to turn the tide.  Capital flight could last for several months pushing a number of countries into a deep recession.  German taxpayers will revolt at the additional exposure.

It is time for European and IMF officials, with support from the US and others, to work on how to dismantle the euro area. While no dissolution will be truly orderly, there are means to reduce the chaos. Many technical, legal, and financial market issues could be worked out in advance.

 We need plans to deal with: the introduction of new currencies, multiple sovereign defaults, recapitalization of banks and insurance groups, and divvying up the assets and liabilities of the euro system. Some nations will soon need foreign reserves to backstop their new currencies. Most importantly, Europe needs to salvage its great achievements, including free trade and labor mobility across the continent, while extricating itself from this colossal error of a single currency.

This should be a good lesson for risk management of a flawed system design and the failure to make corrections.  What is your euro exposure?

For more on this, follow the link: http://tinyurl.com/bsan8zc

Giant chickens and Marks!

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

There’s a giant game of chicken going on and many are predicting that it will end up with Greece exiting the Euro and returning to the Drachma.  This is seen as likely to lead to disaster for the Eurozone and many others, but especially for Greece.  However, there is a simple way to make it beneficial for all.  Why should Greece return to the Drachma?  If Greece is first out, the name “Mark” is going spare.  An announcement that Greece will adopt the Mark as its currency would calm markets and lead to a dramatic reduction in Greek debt yields ……….

 

OK, totally crazy and irrational I know.  But if rationality had anything to do with things, there likely would not have been a Euro in the first place.  Even if there had been, it’s a racing certainty that Greece would not have been a participant.  Politicians running currencies and economies is a bit like the animals running the zoo.  One thing we can rely on is a mess and sub optimal outcomes.  I hope your risk management systems and processes have this assumption.

 

Risk in the G10 Foreign Exchange Markets

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The G10 foreign exchange market is likely to enter a more challenging environment as problems in Spain are starting to refocus investor attention on the underlying structural problems in Europe and continued deterioration of the financial condition of European banks.  The ECB has not given any indication of injecting further liquidity into the banking system if the situation in Spain deteriorates and/or spreads to other countries.  Leading indicators in many advanced countries are starting to show weakness suggesting that growth for Q2 and Q3 could be lower than earlier estimates.  In this environment, investors and corporations may want to re-evaluate their foreign exchange exposure as the global economy enters a more risk-averse, slower growth environment. 

 

Meanwhile, policy-makers and central banks are becoming cautious about major policy changes.  The US deficit continues to overhang the Presidential election as major parties refuse to compromise over spending cuts and tax reform.  A potential showdown on raising the debt ceiling could provide temporary market uncertainty.  In Europe, a number of countries are reconsidering fiscal austerity as the economic costs could cause a shift in the political landscape.

 

Elsewhere, central banks remain cautious about providing further liquidity over concerns about central bank balance sheet size and asset quality. The ECB has not provided any indication of adding further liquidity, but may be forced to if Spanish banks have further problems.  While central banks in Japan and Australia are active in adding liquidity, most G10 central banks are content to keep policy steady.

 

In an environment of slowing global growth indicators together with the reduced prospect of a monetary policy response could make the euro more vulnerable. Currently, any tightening of global liquidity conditions suggests a negative impact on the high-risk currencies, especially the euro.  The spotlight remains on the peripheral Europe, especially after Spain’s rating downgrade, the collapse of the government in the Netherlands and the shift in political sentiment in France.  Fiscal problems at the periphery of Europe could be quickly transmitted to core countries, also adding to political uncertainty.  In this environment of stagnating growth and ongoing structural problems could keep the euro under pressure well into 2013.

 

In Japan, the continued support from the central bank and some signs of a rebound in growth should provide a base of support for the yen.  The yen will have support from better economic prospects in Asia.  In contrast, weaker growth prospects in the UK may cause temporary sterling weakness.   Recent weaker UK data has taken some of the steam out sterling and could test the BoE’s willingness to hold policy steady.

 

In other major currencies, the Aussie could experience some weakness as the key support points of stronger growth and favorable terms-of-trade are showing signs of deterioration.  Already, the RBA has started to ease policy in expectation of further economic weakness.  In contrast, the hawkish stance by the BOC, favorable fundamentals and steady growth prospects should keep the loonie well-supported against major currencies.

 

If the global economy shifts towards a slower growth and more risk-averse environment, the euro could come under further downward pressure.  This may include some modest pressure on sterling and the Aussie dollar.  Have you examined your foreign currency exposure?

 

Is it time to reassess your hedging practices?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Do you have Euro exposures?  Are you worried about the Euro exchange rates?  Are you concerned that volatility will also affect other currencies, perhaps through flight to quality? 

 

As a result, are you scrambling around looking for additional hedges?  If you are, then you should consider if what you are doing is more speculation than hedging.  You should also consider a thorough review of your hedging policies and practices.  A well-conceived hedging policy should be designed precisely for volatile situations such as this and to allow time for longer term adjustments to be implemented. 

 

That is not to say it shouldn’t be constantly reviewed and updated.  It should be.  However, it should not be prone to significant, sudden and little considered changes in times of volatility.

Virginia Two-Step Approach to Risk Management

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

As the European debt soap opera continues, Europe’s leaders have expressed their willingness to “do whatever it takes” to restore financial stability and save the euro.  This is very similar to the Virginia dance that moves two steps forward and then one step back.  Morris Goldstein, Stop Coddling Europe’s Banks (VOXEU, Jan. 11^th), argues that policymakers’ actions too often serve the banks at the public’s expense. 

 

Policymakers now acknowledge the wisdom of comments by IMF Head Christine Legarde at Jackson Hole (2011) about the need to recapitalize European banks.  Goldstein indicates five concerns to address: incentives for deleveraging, guidelines for dividends and compensation, alternative macro scenarios for stress tests, burden sharing during restructuring and measures to address feedback loop on sovereign and bank debt. 

 

The European Banking Authority (EBA), however, specifies a bank capitalization target (but not one made mandatory by national authorities) as a ratio to risk-weighted assets rather than converting that ratio into a target for bank capital alone.  Banks may sell assets and tighten credit when new lending is needed. 

 

The EBA advises banks to tap private-sector sources for recapitalization, but does not provide guidelines for either dividends or compensation.  This is no directive for banks falling below the capital target on the payment of dividends or executive compensation. 

 

The bank stress test scenario focused on mark-to-market losses on sovereign bonds and did not consider alternative macroeconomic scenarios (including much weaker euro area private forecasts).  Bank capital positions were assessed only against a risk-weighted standard and not against an unweighted leverage target.

 

European Council, at the December Summit, decided to reverse its earlier position of private sector involvement; it announced that private-sector burden sharing would no-longer be required beyond the restructuring of Greek sovereign debt.  This implies that the taxpayer will have to absorb any losses while the private-sector is the beneficiary of any upside potential.  

 

Lastly, there is the problem of the adverse feedback loop between sovereign debt and bank debt.  There are a number of long-term solutions, including a tougher fiscal compact, a bank capital target or a permanent financing facility.  One short-term solution might involve the issuance of bonds with a risk-sharing mechanism. 

 

While not mentioned in the paper, the slow plodding by EU policymakers, has not resolved the agency problem for European banks still subject to national regulation.  As a result, these banks come under political pressure in their home countries to take additional sovereign bond exposure after any poor auctions.  This has pushed a sovereign debt crisis into a banking crisis raising the risk of contagion and the cost of resolution.  The temporary ECB liquidity facility provides a temporary solution and kicks the can further down the road.

 

If one examines the stance the official sector has taken toward banks, it looks like Euro zone leadership allows large banks to do what they please, even when they act in their own narrow interest rather than in the wider public one.  It is not an optimal risk management paradigm of two-steps forward and one step back.  It is time for a change.

 

For more information on this please follow the link: www.voxeu.org/index.php?q=node/7511

Foreign Exchange Risk for 2012

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

As we enter 2012, the euro has emerged as the weakest currency against the US dollar among the major currencies.   Investors still continue to short the euro on expectations the currency move lower is not finished.  This view is based on the ECB facility is a stop-gap measure and does not resolve the solvency issues.  Investors note the following: the Greece refinancing led by the IMF is still not functioning as expected, the cost of Italian and Spanish debt still remains around 7%, European banks are having a difficult time raising new capital and real investors lack additional appetite for further euro risk exposure.

 

Global economic indicators have started to improve, especially in the US.  However, the demand for European risk assets remains weak as the focus remains on a potential recession and contagion impact to the global economy.  Previously in 2011, anytime the euro came under pressure it was often followed by a countertrend rally.  However, 2012 could be different as real non-European investors continue reducing their euro sovereign bond exposures.  The supply surge of sovereign debt, euro $1 - 1.2 trillion, coming to the market in 2012 and the rollover, euro 700-800 billion, of bank paper/new capital could cause digestion problems as global investors to reduce European exposure.

 

In 2011, the US dollar was used as the funding currency for risky assets.  Given the prospect of a European recession, will cause the ECB to further cut rates and keep them low for an extended period.  The poor reception of capital market issues of European banks suggests that further balance sheet contraction is needed to meet the higher capital ratios.  Banks continue to place funds with the ECB and not employing the central bank liquidity in the real economy.  Real yields have moved into negative territory as the ECB tries to promote an investor shift into riskier assets.  The problem is that the time lag between liquidity creation and a move into risky assets has a time lag.  However, the uncertain outlook suggests this delay may take an extended period of time.

 

The use of the euro as a funding currency rather than an asset currency, a prolonged period of low ECB rates, the prospect of a European recession and uncertainty from the overhang of sovereign/bank debt will push the euro lower.  There will be limited countercyclical euro rallies compared to 2011.  The euro downtrend should continue through the summer until either political gridlock in Washington grabs investor attention as the November election approaches and/or policymakers can provide a resolution for the sovereign debt/banking crisis in Europe.   

Do I think the Euro will still be around in 5 years?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The short answer is yes.  And this is due to self-interest, particularly for Germany.  The Euro has certainly been a weaker currency for Germany than a stand-alone Deutschemark would have been.  At the same time it has been a stronger currency for many other Eurozone countries than stand-alone currencies would have been.  This might have been expected to force the latter countries to become more productive and remove some compulsion for Germany to become so.  In fact, Germany has improved productivity substantially over the life of the Euro and produced very strong export performance helped by a weaker Euro.  At the same time, other countries, notably Italy have not restructured, or notably improved productivity, and fallen behind.  However, their borrowing costs, until recently, have been low.  Germany has in effect been benefiting from a weak currency policy (like China has) relative to its economic strength, under cover of the common currency. 

 

If weak Eurozone countries left the Euro, their currencies would likely plunge dramatically making it even more difficult to repay debts that would still be denominated in Euros.  This would apply not only to sovereign debt, but also to corporate debt.  Large bankruptcies and default s would follow resulting in massive losses for German banks that are hugely exposed to these countries.  As import costs for these weak countries would soar, German companies would also lose significant export markets.  Also German goods internationally would be more expensive with a stronger Deutschemark

 

Conversely, if Germany left the Euro, a new Deutschemark, would soar compared to the new weaker Euro and other currencies hitting German exports globally.  German banks would incur large losses as their Euro exposures lost value against the Mark.

 

In short, there is certainly going to be large cost for Germany arising out of all this one way or the other.  They have benefitted from the Euro for over 10 years and now will have been shown to have squandered part of the surplus generated by providing liquidity to unreformed weak economies.  Ensuring survival of the Euro is probably the least bad course, which is why I think the Euro will still be around in something like its present form in 5 years.

Do you think the Euro will still be around in 5 years?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Perhaps “in its current form” should be added to that.  For any corporate treasurer, this is an important question and should encourage them to re-examine their currency exposures and hedging practices.  (Exposures may include hidden exposures like imported components in goods bought from domestic suppliers for example.)  The effects of a Euro break up, or of a change in its form may well be felt much more and further afield than most people might realize.  An independent analysis and view might be appropriate for many businesses.  Whatever your view, this should be on the radar as high risk.

 

Too little too late has characterized all or most actions during the current crisis.  Denial, prevarication and changing positions have also been in plentiful evidence.  Of course, it is politicians of various different stripes and different nationalities and cultures that are trying to find a common solution to the problem.  Not necessarily the recipe for a timely, practical and effective solution.  The main player, Angela Merkel, has been trying to keep domestic political balls in the air during all this and that appears to have precluded swift and decisive action. 

 

Of course it could be argued that without going to the brink, countries like Italy will not institute any truly effective reforms.  On the other hand, the longer it takes to come to a satisfactory solution, the higher the cost is likely to be and the higher the risk that the house of cards will come crashing down.

 

There seems to be an intent to maintain the Eurozone in its current form.  However, when going close to the brink, events can get out of control and unintended consequences come about.  (Look back in history to how the First World War started.)

 

 

Next: Do I think the Euro will still be around in 5 years?

Euro Outlook: Fundamentals versus Market Sentiment

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The euro has rallied against the US dollar last week ending the week just below 1.39.  This rally does not appear related to yield differentials.  Current Euro-US short-dated bond rate differentials would suggest a weaker euro against the dollar.  Economic fundamentals and market sentiment are clearly out of line and pose potential currency risks.

Bond investments tend to be one of the largest cross border flows.  Any divergence between currency values and rate differentials suggests that decisions to buy and sell currencies may be related to other factors.  It is possible that as European banks may be repatriating funds in anticipation of reducing their balance sheets.  The rising losses on Greek sovereign debt and bank share trading below book value limit flexibility in raising funds from private investors. This suggests that shrinking the balance as one method to meet capital requirements.

When banks start a deleveraging process, the first adjustment is made to overseas business that is considered non-essential.  A second adjustment may occur when banks attempt to reduce their short-term funding requirements, especially in non-core currency markets away from the euro.  In particular, this could impact trade finance and commodity finance where European banks are major players.

The fact that the euro/dollar is not trading in line with rate differentials suggest other factors may be supporting the euro.  This has allowed the euro to withstand selling pressure against the dollar.  This may allow the euro to be well supported against the dollar as long as repatriation flows continue.  As banks reduce their balance sheets, the impact is deflationary for markets and negative for asset prices.  The impact of European bank deleveraging and potential credit rationing could have a strong impact on European growth prospects.

Therefore, the prospect of weaker growth prospects and the gradual ending of financial institutions repatriation could spell weakness for the euro as economic fundamentals start to reassert themselves.  What is your hedging strategy?  

Create a currency and hope for the best!

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

So the markets heaved a big sigh of relief as Germany’s parliament today (Sept. 29) approved increased powers for the European bail out fund. Armageddon postponed.  But perhaps not for long.  This is the last proposal that has now been approved by most of the 17 Eurozone members.  However, it has been recognized that it is grossly inadequate and more and greater contributions are proposed.  The trouble is that the Euro was born as a political animal and was, as we now know (if we did not realize it before), flawed.  In its early days, France and Germany flouted the stability pact rules with impunity.  After all, was Luxemburg going to insist on those two countries being fined?  Since then, Italy, Greece and others have not, to put it mildly, observed anything like prudent fiscal policies.

 

For some time now, markets have been way ahead of the politicians who are floundering around, partly in denial and partly trying to protect their own jobs and partly wondering how to recognize which is the front end of a cow.

 

Meanwhile options are becoming more and more limited.  The politicians will muddle through to a solution in the end but the real question is how long will it take to get there and how much damage will be done before they get there.

The Euro Crisis Reaches the Core – What is your Risk?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

The author, Daniel Gros, noted in a recent communique (VOXEU, August 11^th) that the current euro crisis has reached the core.  Investors and treasurers need to ask themselves what is their exposure in a worst case scenario?

 

Investors anticipate the unraveling of the 21 July 2011 “solution” and a potential Lehman type breakdown of the interbank-market and put the European economy into an “immediate recession” like the one experienced after the Lehman bankruptcy. The European Financial Stability Fund (EFSF) was designed to provide liquidity financing and not solve solvency issues.  Gros argues that without quick and bold action such as giving it access to unlimited ECB re-financing there will be a generalized breakdown of confidence.    

 

Greece is not interpreted as a special case, but viewed as the manifestation of a general problem: (1) as a sign that the Global Crisis was spreading to public debt; and (2) as a sign that capital markets would no longer refinance excessive levels of public debt, especially in the Eurozone members who could no longer rely on central bank support.   The EFSF was sized to provide the financing promised to Greece, Ireland, and Portugal and provide lower rates for their long-term financing.  However, if the borrowing costs of Italy and Spain stay at crisis levels, how can they be expected to provide billions in euro in aid to peripheral countries at 3.5% when they pay a much higher rate?  Any decline in the core Eurozone members that remain to back the EFSF and the debt burden would become unbearable. Italian government debt alone is equivalent to the entire German GDP. 

 

The situation is critical due to a domino effect. At this point the Eurozone needs a massive infusion of liquidity.  Given that the cascade structure of the EFSF is part of the problem, the solution cannot be a massive increase in its size.   

 

Banks are the weakest link due to European debt exposure.  This increases the cost of capital for banks exposing them to a breakdown in the interbank market and credit circuit.  If the EFSF was registered as a bank and given access to unlimited re-financing by the ECB, it is the only institution to provide liquidity quickly and in convincing quantity.  This solution has the advantage that it leaves the management of public debt problems in the hands of the finance ministries, but provides governments with the liquidity backstop that is needed when there is a generalized breakdown of confidence and liquidity as a lender of last resort.  A massive increase in the ECB’s balance sheet (which if the US experience is any guide will not lead to inflation) constitutes a lesser evil compared to a breakdown of the Eurozone financial system.

 

What is your exposure to European sovereigns and banks?

http://www.voxeu.org/index.php?q=node/6853 

 

A Square Peg in a Round Hole – Politicians Create Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

European politicians, in their attempt to create the euro, did so with the view that one size fits all.  In this case, they overlooked basic economic fundamentals such as competitiveness, labour productivity and assumed a uniform monetary policy should be the same for all countries.  They did not think to establish guidelines to monitor potential risks.  This question is now being asked.

 

Is Europe an optimal currency area? Is the euro doomed?  The author, Carlo Faverro, argues that economic differences within Europe, exposed by the current crisis, are reasons to doubt the sustainability of the single currency.  One element is an optimal currency is an area-wide monetary policy associated with country-specific and very heterogeneous nominal and real long-term rates. 

 

The author looks at the relationship between long-term rates from the pre-EMU period through the next 10-11 years after EMU formation in 1998 and the subprime financial and euro debt crises.  The first period showed nominal yield differentials associated with inflation differentials.  After the euro introduction, nominal and real long-term rates converged as inflation differentials disappeared.  However, in the crisis period, long-term rates have diverged as long-term real rate spreads have gapped higher, despite minimal inflation differentials. 

 

The ECB’s common monetary policy controls short-term policy rates, but does not control investment and consumption -- key components of growth that depend on real bond yields.  High real long-term rates negatively impact consumption and investment, especially in peripheral countries where growth is needed to help fiscal stabilization.  The common currency has prevented exchange rate movements that normally offset emerging growth differentials.  The peripheral countries are experiencing higher labour costs, loss of competitiveness and surging deficits: factors that could dampen growth prospects.  The inability to reduce fiscal deficits may not be enough to restore real long-term yield convergence.  The doubtful attempt to sustain a common monetary policy with differential economic impacts casts doubt on the sustainability of the euro as a common currency area.  However, it might be reduced to a smaller area.

 

Do you know your potential exposures and risks?

 

For more on the Euro’s current issues, click on the link:  http://tinyurl.com/42c23vj  

 

Sovereign Risk and Unintended Consequences

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

(Fiscal Monitor – Staying the Course on Fiscal Adjustment, IMF, June 2011) The IMF noted in its latest interim Fiscal Monitor that government actions to address budget deficits continue to make progress in the advanced economies – especially in core Europe, Australia and Canada.  This improvement is driven by recovering activity and higher revenues.

Despite the good news, there remains some doubt about debt sustainability and the political will to maintain austerity programs in countries like Greece.  Credit default spreads (CDS) are at new highs for Greece as investors worry about contagion.

Elsewhere, the US and Japan are slow to implement plans to control budget deficits and rising debt levels.  However, the US deficit for 2011 will be lower than earlier forecasts and similar to 2010 on a cyclically adjusted basis.  Policymakers urgently need to reach a consensus medium-term adjustment plan to avoid potential market distress.  Japan lacks a specific plan to address rising debt and contingent liabilities of an aging population.  There is a rising risk perception in peripheral Europe led by Greece, Ireland and Portugal followed by some concern about Spain.  Downward revisions for growth in Greece and Portugal have created more urgency. This underscores urgency for these countries to implement an adjustment program and develop a comprehensive and consistent approach for crisis management and adherence to Eurozone policies.  The record for emerging economies remains mixed as a number of countries are implementing fiscal consolidation at an appropriate pace.  In others, fiscal policy must be tightened quicker to avoid the potential risk of overheating.  Long-term, countries must implement policies to reduce imbalances and government market intervention.

The improvement in the outlook for government finances in a number of countries is overshadowed by recent events.  The surge in the CDS premiums for Greece raises a few questions – is the CDS exposure held by a few institutions or widely dispersed?  Can the institutions payout the billions required in a default?  Do we have concentrated risk such as AIG?  This is something that policymakers or regulators cannot answer.  

 

The Failure of Risk Management: A Preliminary Look at the Cost of a Greek Bailout

Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

European politicians, when creating the euro, failed to consider the risks of their actions.  Policymakers looked at developments in Greece as a temporary liquidity squeeze rather than a solvency crisis.  Paolo Manasse wrote on this issue in a voxeu communiqué called “Greece, The Unbearable Heaviness of Debt”.   He noted analysts have been arguing that Greece will default on part of its debt – leaving its creditors to take a “haircut”.  Manesse argues the prospect is becoming more likely.

 

S&P further downgraded the junk rating of Greek debt reflecting the larger than projected budget deficit and the unsustainable growth rate of government debt.  They estimate a 50% haircut may be required to restore solvency.  There are expectations of a euro 50-60 billion loan from the EU/IMF, which at best may provide temporary relief.  Currently, the only other alternative to debt restructuring, is to leave the euro which seems extremely unlikely.  The rising interest rate on Greek debt combined with new debt issuance/borrowing indicates that the stock of debt is growing much faster than GDP, which is not sustainable.

 

Currently, there are three potential tools to make Greece’s debt sustainable: lowering the interest rate on outstanding debt, turning the primary deficit into a surplus, or writing down the existing debt stock.  A reduction in the market rate may provide a cushion for Greece.  Any move to a primary budget surplus would most likely cause social unrest.  The most likely scenario would be restructuring plus new money at a concessionary rate.  Eurozone bank exposure to sovereign Greek debt is estimated around $100 billion according to the BIS.  Any write-down of Greek debt along with the need to recapitalize the banks will be an expensive lesson on risk management.

The Euro will affect us all

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

  

Recent talk had been of Germany, France and other relatively strong Eurozone countries withdrawing from the Euro.  This talk has now turned to the possibility of weak countries like Greece, Portugal and others withdrawing from the Euro.  If that happened, their new domestic currencies would surely immediately depreciate massively.  However, they would still have unsustainable debt levels denominated in Euros.  At the same time, the Euro would quite possibly strengthen thus exacerbating the problem.  This would necessitate an immediate requirement to restructure and debt holders would need to take significant write-downs on the debt.  Actually, the underlying economies do not support existing levels of debt and current actions are really only delaying the inevitable.  Sooner or later, recognition of loss of underlying value must happen. 

 

Many of these debt holders are banks in Germany, France, etc.  German taxpayers, and hence the German government, are very strongly opposed to bailing out the weak Euro countries.  However, eventually they may effectively have to do so to some extent if their banks need bailing out.  Weak countries exiting the Euro would precipitate immediate action.  However, markets are pushing for early action in any event with bond yields for weak countries going through the roof.

 

All this has the potential to cause great volatility in foreign exchange rates and that volatility will likely go way beyond the Euro.  That will affect any business transacting in foreign currencies.  It will affect other businesses with significant indirect foreign sourced inputs, e.g. through their suppliers sourcing foreign components, and all consumers. 

 

Any business not assessing their FX exposures and formulating risk management strategies to deal with such exposures is taking a big gamble.  It may be that, for any individual business, the risk is within tolerable limits.  However, wouldn’t you feel more comfortable if you came to such conclusion from a proper assessment rather than just having a gut feel that this must be the case.  Guts can be very sensitive to a little bad food input.

The Underpricing of Risk – What Can We Learn?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Jeffrey Frankel, in a recent Vox communiqué called “The ECB’s Three Mistakes in the Greek Crisis and How to Get Sovereign Debt Right in the Future”, reviews the failure of the European Central Bank (ECB) and policymakers to fully integrate Greece into the Euro and fulfill the necessary conditions for membership. .

 

The first mistake, by the ECB and the European Commission, was to allow Greece to join the Euro in 2000 when it failed to meet the economic criteria established by the Maastricht Treaty, particularly the 3% ceiling on the budget deficit expressed as a share of GDP.  The second failure by European authorities, was to monitor budget deficits and debt levels that exceeded limits established by the Stability and Growth Pact, resulting in Greek borrowing costs similar to that of Germany.  As a result, international investors grossly underestimated potential risks.   The third mistake was not to send Greece to the IMF earlier.  European policymakers looked at the events in Greece as a temporary liquidity crisis rather than outright insolvency.  The result is a higher cost for a bailout.

 

There are two major lessons learned by policymakers from the Greek experience.  The first is that when specific criteria are established, such as the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability and Growth Pact (1997), someone has to take responsibility for monitoring and enforcing them. The second lesson is that European authorities are not equipped to impose policy conditionality in rescue loan packages; this is the IMF’s job. International politics is less likely to prevent the IMF from enforcing painful fiscal retrenchment and other difficult conditions. Europe is no different in this respect than Latin America or Asia.

 

The failure to price risk correctly is now resulting in European policymakers discussing the possibility of a “soft restructuring” of Greek debt.  The term soft restructuring is used as a euphemism for extending the maturity of outstanding debt.  European authorities are looking for further spending cuts and increased privatization by Greece.  However, the failure to do the large-scale debt restructuring, increasingly demanded by investors, will increase the ultimate costs.

Foreign Exchange Wrecking Ball

by Stephen McPhie, CA

Partner, RSD Solutions Inc

www.RSDsolutions.com

info@RSDsoulutions.com

 

 

If currency exchange rates have been volatile over the last few years, we are possibly looking at volatility squared over the next few years.  Portugal is joining Greece and Ireland in being bailed out.  These economies are relatively very small in the Eurozone.  However, many are wondering if Spain and then Italy will be in the cross hairs next and these are not small in the scheme of things.  Certainly Spain looks much better in many ways than Portugal but an employment rate in excess of 20% is a massive burden. 

 

Having been an observer and sometimes a victim of several economic cycles, I know that events, markets and politics can gain an unstoppable negative momentum.  Prices and rates tend to overshoot their proper level and correct, usually with little disruption on a macro scale.  However if a giant wrecking ball overshoots, it can knock down several buildings and that is a whole lot more difficult to correct.

 

Add to this the increasing number of voices expressing doubt over the whole future of the Euro itself, especially in the 2 large triple A rated Eurozone economies of Germany and France.  Especially so in Germany where more and more people are disquieted over the prospect of paying a high price to prop up much less developed Eurozone countries in order to save the Euro.

 

The Euro itself was a political creation.  It was weakened in its earlier days by Germany and France ignoring the fiscal rules.  Politicians are trying hard to ensure survival of the Euro.  For now, that is.  However, politicians do not always operate in a long term economically optimal way.  After all, politicians’ careers depend on voters in their own country at the next election and not on wider Eurozone’s economics.  Political winds can change direction very quickly.

 

All this suggests increasing exchange rate volatility.  While it does not appear likely that the Euro will die in the near term, there is a giant wrecking ball swinging around that has the ability to knock down a few houses.

 

Do you really have a handle on your company’s FX exposures?  Do you know the natural hedges and economics of your derivative hedges?  Have you done a full and proper evaluation of all this?  I have seen many companies that are comfortable with their positions until that giant wrecking ball comes crashing through the wall.