14th July 2009
How you could profit from
a crisis in the eurozone
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Welcome back.
As promised, this week we will take a look at the euro as a currency and try to think what could happen if this recession lingers on for a while longer.
A few weeks ago, we discussed the current situation in Latvia and the troubles the country is having in trying to maintain a fixed exchange rate against the euro. Latvia is a small country and unless a domino effect is triggered, the consequences of a devaluation could be quite limited. Now, I happen to believe that if Latvia devalues there's a very high chance of a domino effect but while many people are rightly worrying about the threat from Eastern Europe, far fewer are keeping an eye on the strains building up within the euro area.
One big problem is that while Latvia can simply devalue its currency to avoid the pain of a massive deflation (although devaluation brings its own problems), this is not an option for a country inside the eurozone. This has resulted in strains building up in the euro system. What could happen as these problems come to a head? We'll look at this in detail below, but in essence, it's quite simple I believe that if a crisis hits a single country in the eurozone, then the result will probably be a disorderly fall in the value of the euro.
This would create two opportunities. The first is to short the euro before it happens; and the second is that once the selling sets in, you can pick up perfectly good assets at bargain prices in stronger countries.
We'll also take a look at how we could have a sovereign default in a eurozone country, and what this could mean. Before we start, I want you to bear in mind that much, perhaps even most, of this newsletter will sound far fetched. But remember that while the UK and the US have born the brunt of the recession already, because their economies are very flexible, in Europe this recession has barely scratched the surface as the welfare safety net and relative rigidity of their economies has lessened the effects for now.
Another important thing to remember is that while the US and the UK can in effect print money to pay government debt, countries in the eurozone cannot do that. There are just three ways to reduce debt, other than by paying it off. You can encourage higher inflation, which erodes the debt; you can devalue your currency (which is similar, but quicker and more painful); or you can simply default on your debt. The first two of these are not an option for countries that use the euro so that just leaves us with one option!
A bit of history first
In October 1990, Britain joined the ERM (European Exchange Rate Mechanism), the precursor of the euro. This was a system of fixed exchange rates among European countries which was supposed to promote economic integration by keeping exchange rates within a band of 2.25% (6% for the British pound and the Italian lira).
The problem was that inflation in the UK was much higher than in Germany. When Germany raised interest rates in early 1990 to counteract inflationary pressure stemming from reunification, the pound and the dollar fell against the DM. The pounds was hit hard and the Bank of England had to raise interest rates to defend the pound; the economy also felt the pain of the depreciating dollar because most British exports are denominated in dollars.
The fact that the UK was running a twin deficit (fiscal deficit and a current account deficit) also contributed to the downward pressure on the British currency. The result? On September 16th 1992, Norman Lamont withdrew the pound from the ERM and the currency duly fell, while a guy called George Soros made over $1bn shorting the pound not a bad day's work.
Italy had a similar story
As we mentioned above, the Italian lira was part of the ERM as well, with a central parity of 800 lire per DM. Italy's problem was that its economy depended on the export of low-added-value goods such as textiles. On top of that, it was dogged by an inflexible labour system, with low rates of productivity growth and a high public deficit (which resulted in one of the largest public debts in the world).
Over the years these different rates of productivity growth meant that the German economy was getting steadily more competitive than Italy. By 1990, Italy was running a large current account deficit (for example, because it was importing textiles from Germany).
Because Italy was also running a large fiscal deficit, it meant there was an imbalance between the supply and demand for lira, with supply much larger because of the twin deficits. As we all know, when supply exceeds demand for a good or currency, the price falls. But in this case the price of the lira (the exchange rate) could not fall because of the ERM.
The system was put under a lot of strain in 1990 when Italy entered recession, partly because of the high exchange rate. The BundesBank (the German central bank) and the Bank of Italy tried to defend parity, but in the end, the lira left the ERM on September 13th 1992 , weakening to more than 1,000 lire per DM.
For a real currency crisis, you have to go to Argentina
The best example however is what happened in Argentina in late 2001 and 2002. In the 1980s, Argentina suffered from severe hyperinflation and the currency was repeatedly changed. Inflation became so bad that the general public stopped accepting payments in the local currency, the austral. In 1991, it was decided to peg the newly created currency - the peso to parity with the US dollar, by allowing full convertibility.
This meant that inflation was immediately brought under control and a new era of prosperity started. Because the Argentine peso paid a higher interest rate than the dollar, while keeping a fixed exchange rate, it was possible for the Argentine government to freely borrow from the financial markets.
This borrowing however was spent on wasteful project and local patronage rather than on improving the competitiveness of the economy, which remained heavily reliant on the export of agricultural products. In 1999 the dollar started to rise sharply (which in turn drove the peso higher) because a lot of money was attracted into the US financial system to play the internet and technology bubble: because of this deflationary force, Argentina`s economy entered recession as its exports lost competitiveness.
Nothing major happened for a full two years. But the recession lingered on and the strains kept on building in the system (capital was fleeing abroad and the public debt kept on growing). Then in mid-2001, the public started to panic and began to withdraw large amounts of money from the banking system. The government was forced to introduce the corralito' (the freezing of bank deposits).
As you can imagine, people became very very angry, because they could not access their money in the bank. They took to the streets for weeks, until the president was forced to flee the presidential palace by helicopter on December 21st 2001. The last stage of the crisis came on December 31st 2001, when the new president abandoned the dollar peg, defaulted on the government's debt, and converted all dollar-denominated assets into pesos. The peso dived from 1:1 against the dollar to more than 3:1, before regaining some lost ground to 2.4 after six months.
Argentine Peso vs Dollar, 3rd January 2001 to present day
Why does this happen? And what can we learn?
All of these currency crises have a similar root cause. Variations in the rate of productivity growth between two economies are usually reflected in the exchange rate. The lower your productivity growth, the weaker you can expect your exchange rate to be. Also current account and fiscal deficits increase the supply of a currency, and so put downward pressure on the exchange rate.
When these pressures can't be reflected in the exchange rate, because it is fixed, then one of two things can happen. The first is that the system simply breaks under the strain, and you have a sudden collapse, rather than a gradual readjustment. The second is that the readjustment is made through falling salaries (to restore competitiveness) and falling living standards (as is happening right now in Latvia).
What does this mean for the euro?
As you probably know, the euro was introduced on January 1st 1999 for financial transactions, and then in 2002 it replaced all coins and notes in circulation in continental Europe. It is now used by 16 European states.
I remember when it was introduced, that a few doubts were raised with regards to its long term future. These doubts mainly focused on the ability of single countries to withstand a fixed exchange rate and a single interest rate. Ten years later, these problems have not yet created major issues, apart from a housing bubble in Ireland and Spain and a boom and bust in Portugal, caused by low interest rates in countries that had weak currencies before the euro.
But now that we have a major slowdown we could be in for some major surprises, especially if - as I suspect - the recession is not sharp and short, but a major and protracted slowdown which lasts for a few years. Such a slump could increase the strains in the eurozone (without anyone noticing) to the point where a single surprise event could be enough to trigger a major crisis.
I am pretty sure that any crisis hitting a single nation would result in a major sell off in the euro as a currency, regardless of the state of the other nations. We've seen in the last few months that when investors start to panic they sell everything - the good stuff, the bad stuff, the ugly stuff it does not matter as long as you cut your exposure. So it's not impossible that the euro could fall by 30% or more - just look at what happened to the pound late last year, never mind the experience of the Argentine peso.
And as usual, this could produce some very good investment opportunities. The early signs of a crisis should be easy to spot, so you should have plenty of time to convert your euros or even short them. Things to watch out for include increased interest rates on a country's debt; repeated failed auctions in government bonds; a government collapsing; riots; governments intervening to support another country; or a bank failure could all be good indicators.
Another interesting scenario could come about if a eurozone nation defaults on its sovereign debt. In this case I would expect to see a sudden drop in the value of the euro, regardless of how other governments responded. This is not as extreme a suggestion as it sounds. As mentioned above, governments have three way to lower their debt pile (other than by just paying it off): inflation, devaluation or default. The first two are the most common ones (either could happen to the UK and the US if quantitative easing goes on for a while longer) but the third is very rare. The problem is that if you belong to the eurozone the first two options are not available - you either have to repay or default!
You might miss the first wave of selling as it could be a sudden event, but be prepared - you should be able to pick up great bargains since people will be dumping euro-denominated assets in all sort.
The countries to watch
Germany: This may sound strange, but Germany has one of the most incompetent banking systems in Europe. What was the first bank that got into trouble because of exposure to subprime mortgages? RBS, HBOS, Lehman Brothers? Nowhere near. Bear Stearns, Northern Rock? Close, but no cigar. It was Industrie Kredit bank (GY: IKB). Never heard of it? Well you're not alone. Nobody had heard of the bank at least, not until it shot to fame as a result of the €10bn government bailout it received in July 2007. And then there's Hypo Real Estate (HRX GY). This group has received more money than RBS and Lloyds put together around €50bn.
I'm not saying that Germany will have a major crisis that's extremely unlikely. My point is that if a crisis happens in a neighbouring country, the German government may well decide that it has enough problems at home and so decide not to intervene .
Ireland: The banking crisis and massive housing bubble are the main problems. A protracted recession could hit the economy further as exports slide. Government debt is heading for 120% of GDP, and the banks remain in perilous state.
Spain: The unemployment rate has jumped from 8% to 17% in just one year. In the first quarter of this year, Spain lost 9,000 jobs per day. The housing bubble was even bigger than the UK's, with entire newly-built suburbs lying empty. The banking system is two tiered. Tier one banks such as Santander and BBVA have hefty foreign exposure (especially to South America), while tier two is made up of local caja de ahorro, which are very exposed to the property sector
Italy: Public debt was not brought under control during the good times. It now stands at 115% of GDP, having averaged 100-110% in the last decade. It could hit as much as 125% next year if the economy does not recover. The yield on 10-year Italian government debt is around 1% higher than that of Germany. It currently yields around 4.5%, which means that soon over 5% of GDP will be spent on the payment of interest on government debt. The country also a very inflexible labour market and produces low added-value goods.
Greece: Again public debt is nearly 100% of GDP - the 10-year bond yields even more than the Italian one. Greece has also witnessed large-scale riots in the past few months.
Portugal: The Portuguese economy has not grown since 2002. It enjoyed a period of boom after it joined the euro and then the economy stagnated. All the readjustment has been made through lower salaries and falling consumption.
What's the worst that could happen?
The most extreme event in my view would be for Italy to default on its debt. Italy is still the third-largest economy in the eurozone and it might be too expensive to save. What worries me is the interest rate differential on the German bund which currently stands at 90 basis points (0.9%) that is, the gap between the German government's cost of borrowing and that of the Italian government.
Italy has benefited hugely from low interest rates and was able to finance all its debt cheaply. But a back of the envelope calculation suggest that if interest rates rise by 1% (not a large amount) then Italy's deficit (revenue minus expenses) would rise by 1%. To cover this increase, tax revenue (which accounts for roughly 40% of GDP) would have to rise by 2.5%. That's a tall order in a country with one of the highest taxation in Europe.
This could set a downward spiral in motion, with the economy slowing further because of high taxes and the growing deficit. It might take a couple more years to reach that point but it's worth keeping this in mind you want to be prepared for these events, rather than just reacting to them.
The conclusion
My view is very simple. If you have a crisis in one country in the euro zone, then the euro will most likely fall against all other currencies. Expect contagion, as I am not sure that US, Chinese or Arab investors will want to hold on to euro-denominated assets and will indiscriminately sell what they can.
In other words, it's quite possible that German and French assets will be sold off if a crisis happens in Spain, Italy, Greece or Ireland. The likelihood of such a crisis is low at the moment, but is likely to grow as time goes by, especially if the economy remains sluggish and does not recover strongly, which is a quite likely scenario.
So be prepared to sell euros against other currencies, and then be prepared to buy assets at knock-down prices once the oversold phase is over.
As usual, if you have any questions or ideas please email me at eventstrader@f-s-p.co.uk.
Riccardo Marzi
Events Trader
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