Europe’s attempts to deal with the Greek crisis are becoming “more nailbiting by the day”, one newspaper said last week.
I’m not so sure. It’s not much of a nailbiter when the outcome is obvious.
Greece doesn’t come up a lot in MoneyWeek Asia. It’s a good 2,000 miles away from where my coverage usually stops. But for a couple of reasons, I’m going to digress this week and talk about the eurozone crisis.
Why? Because firstly, I think Asia tells us something about what is likely to play out in Greece, Ireland and Portugal.
And perhaps more importantly, investors need to think about whether these problems should affect their strategy in Asia and other emerging markets.
What are the odds of a Greek default?
We hear endless debate about the Greek problem. Will a rescue package be agreed or won’t it? Will the Greek government hold on or will it be forced from office? Will the euro break apart or can it be saved? These all focus on very specific arguments about Greece and the eurozone.
But by focusing on this specific case, we lose sight of more general examples from history. The euro is just one currency pact. What is the track record of past currency pacts and fixed exchange rates? It is, says Dylan Grice of Société Générale, pretty poor:
“The Gold Standard, the Gold Exchange Standard, the Latin Monetary Union, the East African Currency Board, Bretton Woods, the Asian economies’ dollar pegs, the Austro-Hungarian krone, the Soviet ruble, the Yugoslav dinar and of course, the original European Exchange Rate Mechanism (ERM) are all examples of fixed exchange rates/single currencies which traumatically buckled under political strains.
“Off the top of my head I make that ten fixed exchange rate systems/currency unions that have failed in the past hundred years or so. In fact, how many such currency unions/fixed exchange rates have succeeded? Switzerland and Hong Kong’s dollar peg (at a stretch) are the only two I can think of.”
So history suggests that the odds of the eurozone surviving in its current form are not good. Similarly, I cannot think of many examples where a huge burden of external currency debt – which is what euro-denominated debt is, because these countries do not control the issue of euros – has been repaid in full.
It’s the remorselessness of past crises that convinces me that Greece will eventually default. So will Ireland. So will Portugal. And absent reform, there seems a fair chance that at least one of Spain or Italy will eventually join them, although it may take much longer, since their problems – especially Italy’s – are rather different.
They are also likely to exit the euro. Admittedly, it’s hard to see exactly how this happens. As soon as you declare that you’re exiting the euro block and introducing a new currency that will inevitably be worth less, all the euro-denominated capital is going to flee your financial system. But it’s equally hard to see how it doesn’t.
Asia’s lessons for Europe
And it’s not just that these countries will default; they should default. They have nothing to gain and everything to lose from spinning out this pretence that the problem can be solved through fiscal austerity and transfers from unwilling German taxpayers.
These economies risk driving themselves into deflationary depressions trying to repay debts that cannot be repaid while their competitiveness is crippled by being tied into the euro. A second Great Depression has been a popular fear in recent years – well, these countries are already experiencing something close to that. Substitute debts for war reparations and the euro for the gold standard and we can see how it’s likely to play out.
Now, if we look back at the Asian crisis of 1997-1998, we see a very different outcome. Foreign currency government debt was not a big factor, but US dollar corporate borrowings were a huge overhang. And exchange rates were fixed to the US dollar at unsustainably high rates (which had helped to encourage the excesses that had gone on before).
So what happened? Foreign currency debt was defaulted on. Ruthlessly, by firms that could have serviced it in some cases. And the currency pegs could not be sustained, so they were cut.
Things did not look good for Asia in the aftermath. But weaker currencies made their export sectors highly competitive. Robust Western consumer demand created an export boom that helped them out of the trough.
Not needing to service a huge debt burden made the recovery much easier. And where countries were forced to go to the International Monetary Fund (IMF) for funding, it came with tough conditions. These were highly painful at the time. But they led to reforms and a clearing out of their rotten banking systems that left them much healthier.
The global climate is not so helpful these days. It’s hard to see a surge in foreign demand bringing back the good times for Irish manufacturing, for example. But it seems pretty likely that Europe’s strugglers will do better by shedding their debts and restoring their competitiveness quickly.
Investors shouldn’t fear panic
This will not be an easy process. There will be plenty of upheaval. When these countries default, some banks and institutions that hold their debt will become insolvent. They will have to be bailed out, yet again.
But the world wouldn’t end. We’ve already seen in the last few years how we got through a global crisis that paralysed much of the financial system. The eurozone problems are far less of a surprise to markets.
Obviously, not every problem that crops up will be predictable. But markets should not be surprised by a default. And governments and central banks should be more prepared to deal with it. More quantitative easing and bank-funding support is very likely over the next few years.
I’m not saying you should ignore the eurozone farce. But don’t let headlines get to you. For fund managers, developments like these are a big headache, as several have told me recently. It’s hard to persuade investors to commit fresh money when markets are turbulent. You also feel pressured to switch into the largest, most liquid stocks so that you can sell easily to meet increased redemption requests.
But for long-term private investors who don’t have these considerations, it’s not so relevant. As long as you can afford to hold through the ups and downs, the impact of a panic is small. In fact, if investors sell-off indiscriminately, it presents a welcome opportunity to buy good assets at depressed prices. This was the case in late 2008 and early 2009 – a time of upheaval that I think Greece is unlikely to top.
So in my view, investors should avoid trying to re-jig their portfolios too much to reflect the likelihood of eurozone defaults. Own good assets, be diversified and have some cash for distressed opportunities. And don’t expect it to be resolved quickly. This will run and run, perhaps for years. But the outcome seems pretty inevitable – even if the politicians don’t want to admit it yet.