No quick fix for eurozone problems

All eyes are on the European Union as it deals with a sovereign debt crisis so potentially disastrous that “the weave that is the European Union is being torn apart at its periphery,” in the words of Dennis Gartman, the influential editor of The Gartman Letter. “These problems are cultural, they are structural, and I think they are long-term problems,” Gartman said recently. “Are these problems going away in the near future? Absolutely not.”

A crisis of confidence is undermining European financial markets. The Euro is losing steam and status as the world’s second reserve currency, and there is considerable strain between nations. A rising tide of social discontent is rippling through Europe.

“The problems of the EU should not be downplayed,” says Dagmara Fijalkowski, vice-president and senior portfolio manager of global fixed income and currencies for the RBC Global Bond Fund. “However, we don’t think there is a lot of appetite for unexpected consequences. From that perspective alone, a resolution of the EU problems is important, and we expect they will find one.”

Greece is perilously close to defaulting on its sovereign debts, and European Finance ministers have given the country until March 16 to come up with a plan to reel in its deficit, now running at 12.7% of GDP, to a more respectable 8.7%. That is still, however, far beyond the limit of the 3% debt to GDP ratio required by the EU rules.

When Germany ditched the Deutschmark in favour of the euro in 1999, it vowed never to bail out EU members that failed to stick to the rules of engagement.

Nevertheless, 10 years on, Portugal, Italy, Ireland, Greece and Spain — the so-called “PIIGS” — are all seeking assistance from the EU and the International Monetary Fund to get their fiscal houses in order.

In Athens, the idea of belt-tightening is not getting much support from Greeks. Meanwhile, unemployment in Germany is an unpopular 8%.

For years, Berlin has been hiking taxes and telling citizens to expect less from their social safety net. Meanwhile, Greece, like a kid with a credit card, was going on a government-spending spree.

To be fair, it seems that Greece’s current socialist government inherited the nation’s current debt crisis to some degree. Beginning in 2004, the previous conservative government was quietly raising vast amounts of cash on the global bond market through derivatives and credit swaps to pay for everything from the Olympic Games to rising pension benefits and public payrolls.

Greece owes about €262 billion. It’s a manageable amount within the context of the eurozone, says Fijalkowski. “However, if you add Portugal, Spain and Italy to the bill, that would not be manageable,” she adds. “Any form of bilateral help would be quite damaging to the German or French finances. A loan/guarantee combination, on the other hand, orchestrated by the European Council would be a less-damaging solution.”

Greece is expected to float a 10-year bond offering in the near future. “We could invest in Greece if we wanted to, but we certainly don’t want to right now,” says Thomas Goggins, senior portfolio manager with MFC Global Investment Management in Boston, adding that there is better risk management value in U.S. corporate bonds and in the sovereign bonds of better-managed EU economies such as Germany, France, Norway and Sweden.

“What we see is essentially a bifurcated market over the next six months or more,” adds Goggins. “However, the ‘bond vigilantes’ could step in and buy Greece bonds, but they will be expecting yields north of 6%. They will want to exact their pound of flesh.”

The reality is, the European Union is a source of pride — much political capital has been poured into making the EU a modern economic powerhouse with a $17-trillion economy and a population of nearly half a billion.

However, if wealthier members ride to the rescue too quickly, not only do they annoy voters, they also leave the door open for other countries to be fiscally irresponsible.

“It’s like giving the populist governments of peripheral Europe carte blanche on spending to buy votes, because they know the bill will eventually be picked up by someone else,” says Fijalkowski.

Even though EU finance ministers are not very receptive to the idea of forking over cash to bail out profligate spenders, their fates are linked. “Sixty percent of Greek debt is held by financial institutions of other eurozone countries,” says Fijalkowski.

Allowing the crisis to continue could lead to some nasty consequences for European banks — no one knows for sure. With an economy larger than that of the U.S., the EU may be just too big to fail, but how to get Europe back on track is a difficult question.

Consider Spain’s predicament. Inflation has been running at 35%, thanks to its sunny climate and a housing boom largely driven by an influx of cash from the U.K. and Germany. The country’s goods became increasingly uncompetitive in foreign markets, and when the housing bubble burst, tax revenues crashed and Spain incurred more debt in order to the keep the country running.

While the EU may be an economic union, it is not a political union. There is no joint tax policy, no joint fiscal policy and no consensus on which industries should be subsidized. There is no way for members to accommodate sovereign issues such as unemployment or inflation.

“All in all, the crisis has shown the flaws of the Maastricht Treaty and the flaws of a currency union being backed by a central bank but not a treasury, which could help when the financial system is in danger of collapsing,” says Fijalkowski.

Brenda Craig is a Kamloops-based freelance journalist.

(02/26/10)