How to play the next stage of the eurozone crisis

published 1 September 2011

The eurozone is in crisis again. After what looked like a short period of calm, the market suddenly turned on French and other European banks, prompting four countries to impose a short-selling ban. Why now? It's hard to tell. France's big banks are woefully undercapitalised there is no doubt about that.

But on paper at least the German majors don't look much better. However, whatever the prompt for the move, the problem here is that France is not supposed to be like Spain, Italy, Greece and Portugal. It is supposed to be on the side of the strong and, together with Germany, the core of the euro project. After all, Germany and France together make up some 48% of euro area GDP. If France is suddenly considered suspect, the future of the entire single-currency concept looks even more dodgy than it did. With that in mind, German chancellor Angela Merkel and French president Nicholas Sarkozy called yet another summit in Paris to put the market's mind at ease. Yet again it didn't do much good.

The summit press conference, two weeks ago, talked about the importance of defending the euro and announced an intention to harmonise corporate tax policy by 2013. It also announced new deficit-controlling rules. But traders aren't much interested in that kind of thing right now: they wanted to see real near-term initiatives. Something along the lines of an increase in funding for the bail-out vehicle (the European Financial Stability Facility, EFSF), or a plan for Eurobonds' IOUs backed by the eurozone as a whole, rather than by sovereign states (not to be confused with the traditional definition of eurobonds. They didn't get it.

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So what next? Currency unions rarely end well. But those that try to combine hard and soft currency nations are particularly vulnerable. Northern European countries are used at least to paying lip service to the puritan virtues of fiscal discipline, balanced budgets and a hard currency. But the peripheral countries, with their culture of Catholicism and the absolution of past sin, seem to prefer currency devaluation over austerity when it comes to dealing with past excesses.

The logical disconnect at the heart of the euro is and always was: how can so many diverse nations, histories, economic models and even cultural mind sets share a single monetary policy, a single interest rate, a single exchange rate? It has taken a build up of imbalances made urgent by the financial crisis to reveal the stark answer: they can't, unless they accept a truly common fiscal union, with transfers from the wealthy parts to the poorer.

Sir Arthur Conan Doyle's fictitious detective, Sherlock Holmes, would have despaired of the lack of logical thinking behind the creation of the euro. Born of political and historical parentage, it only ever pretended to be a robust economic entity. Now that Greece leads an increasingly desperate pack of naturally soft currency nation states towards the precipice of default, it's worth remembering Holmes's maxim: "When you have eliminated the impossible, whatever remains, however improbable, must be the truth." If we strike off outcomes that can't occur, we see more clearly what, however improbable, the most likely denouement of the European crisis will be.

First, the impossible. No country can be expelled from euro membership, so Greece's departure would have to be at its own behest. Does Greece have incentives to leave? Sort of. Leaving would mean it could restructure its debts. The new drachma would presumably be valued at a substantial discount to the euro, so foreign creditors would receive only cents on the dollar. Greece would be a pariah for a while. But eventually, with a convincing strategy and a free-floating currency, it could return to the bond markets again.

The Basle II capital adequacy rules that applied to European banks allowed them not only to inflate regulatory capital far above forms that could actually absorb a loss in the event of a default, but also to hold very little of this inflated capital against what were deemed to be low-risk assets. The lowest risk assets, so-called risk-free, were Organisation for Economic Co-operation and Development (OECD) government debts. Banks hold no capital against Greek and other peripheral nation government bonds. If Greece devalued, anyone who had lent to Greek residents be they in the public or private sector would suffer substantial write-downs.

The inherent weakness of the European banking system makes other potential solutions' impossible too. When Irish banks failed shortly after passing the laughably benign stress tests run last summer, Ireland was faced with letting Irish bank bondholders take the loss, or taking the liabilities on the national balance sheet. Enormous pressure from the eurozone persuaded the government to make taxpayers take the hit rather than bank creditors, mainly other European financial institutions. Why? Because again, such assets were treated as low risk and so were barely supported by capital. Had the banks been made to take their losses, there would have been a Europe-wide bank crisis.

The fact is that the preponderance of weak bank capital (even most Swiss, French and German major banks are 30 to 40 times leveraged) precludes any solutions' that would trigger write-downs. This is at the centre of the explosion in national debt-to-GDP ratios. The Maastricht entry requirement was set at 60% because, according to International Monetary Fund (IMF) data, the benefit to GDP growth that a country gets from extra debt-funded spending starts to shrink once total indebtedness exceeds this figure.

By the end of the year, the G7 industrial countries' average debt-to-GDP is expected to exceed 100%. Historically, the IMF has found that above this 100% mark, extra debt-funded government spending has no impact on GDP growth, or even hurts it, as consumers start anticipating higher taxes (and so cut their spending). They're right to do so. Taxes have been rising fast in Britain and the French are planning to raise taxes too.

The impossibility of pursuing options that would result in significant bank losses (at least in the absence of a huge re-capitalisation for which read nationalisation of banks) leaves only a limited set of prescriptions that Germany and France can write. Those responses to date (the second Greek bail-out, the purchase of Spanish and Italian bonds by the European Central Bank and the use of the EFSF to effect national bail-outs) don't solve the problem. Worse, they may not be legal. German courts are considering whether to challenge bids to direct funds from creditor nations to deficit ones.

So what would Holmes conclude? If less' Europe isn't an option then the political preference for more' Europe, however improbable, must win out. The appeal of joining the euro for the soft currency nations was originally the lower borrowing costs these resulted from the assumption that national debt was backed by the whole euro area. One obvious solution is to make that assumption explicit by issuing Eurobonds. Sarkozy hasn't dismissed this idea (he just says "not yet"). But so far Merkel has been clear that this deal isn't on the cards. Merkel is a Japanese-style, consensus-building politician facing a hostile electorate back home. That electorate has nasty memories of the cost of stabilising the much smaller East Germany. Doing the same for all of Europe fills them with terror.

But German obstinacy isn't the only problem with Eurobonds. The other is discipline. If soft currency countries could issue unlimited Eurobonds (and use them to buy their own high-yielding, low-priced existing debt) they could refinance themselves at a lower average rate say what the French pay now. That would be good. But there would be no reason for them to stop there. Pretty soon Eurobond issuance would flood the market and rather than the Greek cost of debt being brought down to France's level, the German cost would rise to something nearer Spain or Italy's. So along with the Eurobond we would need enforceable rules governing how much debt countries could have.

In this light, the Paris summit takes on more relevance. Sarkozy and Merkel (or Merkozy') didn't talk about increased funding and Eurobond issuance, but about stricter regime of fiscal boundaries and harmonised tax regimes. And that's the starting point for the bonds. The prospects for 2012 almost everywhere were always for (ineffectually) loose monetary policy but a more restrictive fiscal stance. But now, fed up with a pointless and reactive response to fiscal sloth and backed by an increasingly unsupportive electorate, Merkozy seem to have agreed that Germany will set the rules. France will get some insider influence and everyone will have to play by the (fiscal) rules. Any country not willing to collect the taxes (Greece, Italy) or impose the spending cuts will risk being subject to increasing foreign provisos and demands. That's a big stick. The only carrot that would make it worthwhile would be access to a Eurobond market. In the end, therefore, a Eurobond might be the only workable way to keep the impossible euro dream alive.

The route, however, is fraught with risks; the most obvious being a rebellion, either by the hard-currency taxpayers if the Eurobond participation rules are not strict enough, or by a peripheral country rebelling against being dictated to in the name of fiscal union and harmonised tax regimes. To date, the strength of the euro, despite the weakness of the banks, suggests the market is anticipating Eurobonds.

But the road won't run smooth. The usual way consensus agreement is achieved, particularly when many stand to lose, is by forcing all involved to choose between a bad outcome and a worse one. That might mean a series of more overt crises before a comprehensive solution, including austere policy harmonisation, can be imposed. Until it is, the risk of a breakaway triggering Europe's version of the US subprime crisis is very real. The euro looks close to the top end of its wide trading range, suggesting a lot of downside risk to the currency should any of these risks break out.

Given that the eurozone will see lots of ups and downs before any sort of crisis resolution is reached, what can investors do in such uncertain times? If you have a high risk appetite, and you like the idea of dabbling in the currency markets, you could try to bet on a slide in the euro. After all, if its eventual fate is to go from being an undercover deutschemark to being more closely identified with the weaker currencies in the region, then it should weaken over time, even assuming it survives.

We still like gold too, although its recent strong run suggests it could be due a correction. And it's also worth holding onto plain old cash. As Dominic Frisby pointed out inour free email, Money Morning, this week, a fairly well-known technical indicator, the dramatically-named death cross', has formed in both the S&P 500 and the FTSE 100. What does it mean? In short, it shows when both the short-term and the longer-term trend in the market is heading down, and the last two times this signal appeared in early 2000, and mid-2008 a nasty crash followed. Will it happen again? There's no guarantee, but it does argue for caution.

The eurozone crisis looks like yet more bad news for banks. But in one way at least, the banks have been trying to turn the crisis into an opportunity. The Independent Commission on Banking (ICB), headed by Sir John Vickers, is due to report in less than a fortnight. Among other proposals, it is likely to argue that the retail arms of banks be split from the investment arms. Put simply, this is to ensure that banks don't use people's savings to take punts on the markets in future. This would make life more expensive for banks, so they'd rather this didn't happen, and preferably that other regulation be kept to a minimum too.

So they're rolling out the argument that now is not the best time to impose new rules. It's just too risky, argues Angela Knight, chief executive of the British Bankers' Association, given the "high degree of uncertainty, market turbulence and lack of confidence that governments in other countries have got asufficient grip on their economies". Economic recovery should be the priority, agrees John Cridland, head of the Confederation of British Industry. Radical reform of the banks right now would be "barking mad".

We can't agree. If anything, Europe's current woes which are, after all, partly down to governments putting banks' best interests before those of taxpayers simply underscore the need to deal with too-big-to-fail banks. As business secretary Vince Cable pointed out to Sam Fleming in The Times this week, "The fact that we continue three years after the 2008 crisis to have anxieties about big financial institutions is all the more reason for grappling with this issue." And as the Financial Times notes, Britain's banking sector is still huge compared to the economy comparable nations include Iceland and Ireland, both of which "collapsed". Reform will be tricky, sure. "But that is not a good reason for failing to make the transition at all."

James Ferguson qualified with an MA (Hons) in economics from Edinburgh University in 1985. For the last 21 years he has had a high-powered career in institutional stock broking, specialising in equities, working for Nomura, Robert Fleming, SBC Warburg, Dresdner Kleinwort Wasserstein and Mitsubishi Securities.