At a recent meeting with policy makers and members of European think tanks in Beijing, it dawned on me that letting the markets force governments into decision making, a process implicitly backed by central bankers, was leading us into potentially unnecessary losses.
Indeed, the current mode of operation means that the important decisions are subjective and made in reaction to market stress. What is actually required is a pre-emptive and objective attempt to resolve a deepening crisis by tackling the cause of the problem rather than its symptoms.
Consequently, with the exception of Draghi’s long term refinancing operation (LTRO) programme, which had the capacity to change the game for a while at least, other measures have been a case of too little, too late. Hence the price of repair is always much bigger than expected and increases over time. This is a point that seems to escape even the strongest members of the European Union.
In any debt crisis, the debtor climbs into the driving seat as soon as the amounts potentially lost by the creditors escalate far enough. Some ‘think tankers’ have been quick to tell me that markets are too impatient. However, I refuse to get drawn into this debate because a reluctance to face an undesirable reality is a trap that we constantly face in our risk management of portfolios. It leads nowhere.
At that meeting in Beijing, I could not merely point out the problems that most knew yet refused to accept – or simply phrase differently, focusing on what is politically palatable as opposed to what is not. Consequently, I thought I would speculate on a possible preventive measure; something that would limit the ultimate cost. Indeed I struggle to justify intellectually why the Germans should pay endless amounts ofmoney to save the European construction. After all, they have already paid for World War II and German reunification. However, I have equal difficulty in understanding their reluctance to acknowledge that waiting for the markets now will result in all of us having to pay much more in the long run.
A sense of deja-vu
The prevailing sovereign crisis, and the efforts made to recapitalise the banks, reminds me of 2009. At that time, I briefly became bullish on bank equities, after a meeting with Bundesbank officials made me feel comfortable that Spain had sufficient resources to ensure long-term solvency. However, Stephen Holliday, my financial sector expert, as well as Steve Roth who runs our credit business, were quick to kill my optimism, pointing out that actually the banks’ capital was not the issue, but funding the other 90-95% of their balance sheet was a huge problem; it is possible to be sufficiently capitalised and yet become insolvent and go under!
As I observe the various bank recapitalisation efforts, I still struggle to see how this will alleviate the genuine concerns that people are expressing. Are the international investors going to come back to European sovereign markets because banks are recapitalised? I would not bet the ranch on that as our leaders seem to. What about the prospect of widening sovereign credits and the possibility that austerity measures will push up private default rates, refuelling the vicious circle?
I also remember how we doubted the efficacy of these leverage acronyms to control the direction of the underlying assets. Soon we will need to reactivate the SMP (securities markets programme) and I simply do not believe that any of these vehicles are capable of preventing a foreign-sell off of Eurozone sovereign debt.
Tackling the sovereign issue directly
As Jamil Baz, our chief investment strategist has said since the beginning of the crisis, the deficit numbers are currently unworkable, as wrong assumptions are being made on the combination of austerity and deficits. Yet, one can make the case that Italy, Spain and Portugal are not insolvent over a medium-term horizon if we change the current objectives. The mistake could be that we are forcing them into too much austerity too quickly. How do we expect to unwind decades of wrongdoing in one shot?
After all, who are we to throw stones? France and Germany quickly breached the Maastricht treaty by crossing the 60% limit on debt-to-GDP long ago (See Fig. 1), an example followed with abandon by other countries now in trouble. This was deemed totally acceptable by all until Greece blew up in 2010. I also believe that what is currently on offer by politicians will take too long. Since 2008, their credibility in execution is so challenged that the markets will act like St Francis and refuse to give them the benefit of the doubt. So we have to stop hoping the markets will accept the promise of reforms without something tangible today.
From a similar perspective, I fail to see how the creation of Eurobonds can be achieved quickly enough to satisfy the markets, without too much moral hazard. (NB: We always have to accept some moral hazard but there are limits!). Moreover, as we all know only too well, the European Central Bank (ECB) has restrictions in its mandate that prevent it from financing states directly.
ECB debt guarantees for a fee
However, the ECB could underwrite the existing and future debt of the Eurozone sovereigns; all of it – without moral hazard. The underwriting MUST be conditional on the country achieving budget deficit and debt targets, within a time horizon of (say) five years. In fact, periods could be framed for each country in accordance with its ability to meet targets; a bit like a debt rescheduling process, based on what people can realistically repay. Lessons from war damage payment and Weimar: give targets which are tight enough to limit moral hazard, but realistic enough that they can be achieved. Additionally, the ECB could consider guaranteeing new short-term debt issued by the sovereigns unconditionally, with the existing debt remaining conditional upon meeting the deficit criteria.
Sovereigns should be asked to pay for the guarantee through (e.g.) a 50 basis points per annum fee. This would create an arms-length transaction, and would be much more affordable than the amounts that the sovereigns will continue to pay if we persist in ploughing the current furrow! This inspiration comes from the astute thinking which saw Italian banks pay 80 basis points for sovereign guarantee earlier this year.
Markets could rebound strongly
If the ECB, backed by the governments, announces something similar to the proposals outlined above, I believe the markets will massively correct the current negative stance. Investors will price in what they perceive to be the probability of countries achieving their debt and deficit targets within the five-year protection period provided by the ECB.
The execution period is much quicker than that required for Eurobonds, fiscal unity and European bank regulation reforms, which can, and should, still be worked on. Moreover, the markets, and hopefully the German parliament, will see that we are gaining the time needed for fiscal adjustment, without moral hazard. Indeed, for the various governments, it will become essential to comply, in order not to lose the guarantee after the specified period, or face a rerun of the Greek outcome!
I have not fully verified the constitutional law aspects, but as this is a guarantee, conditional, and paid for, it is hopefully not in breach of treaties in a manner that cannot be resolved. (NB: The treaties will be breached big time if nothing practical is done to prevent the disaster scenario from happening!)
One of Martin Wolf’s columns in the Financial Times stated that “the current solution to the imbalances inherent to the euro design, a mix of fiscal austerity and structural reform, will probably not work. If the current policies seem unlikely to work and either a federal or a transfer union is ruled out on the grounds of political or economic unfeasibility, what is left?” Martin went on to suggest a combination of two ideas; an insurance union, one that provides temporary support for countries hit by shocks, and an adjustment union, which ensures symmetrical realignment in the event of a more permanent change in circumstances. My proposal is therefore a direct application of Martin’s theoretical musing.This system should be applied to those countries that have strong prospects of returning to solvency, given the time. Greece has probably gone too far, and is unlikely to qualify, so here is another thought; instead of providing futile support to keep Greece inside the euro, we should keep that money to help them outside the euro, with a flight path to potentially regain access in five years. A Marshall (Merkel) plan for Greece?
Indeed, while I have total sympathy for trying to preserve the European construction and limit the humanitarian disaster unfolding within it, I have yet to see anyone making a realistic case as to how Greece can possibly remain within the Eurozone, without the moral hazard of writing off their whole debt.
Food for thought!
Pierre Lagrange is Senior Managing Director of GLG and manages its global long only and long short equity portfolios out of London. He is also an Executive Committee member at Man Group and Chairman of Man Asia.