Going long on European deja vu

Published in Business Spectator (Melbourne), 3 November 2011

Markets were euphoric, political leaders relieved. “Europe has taken a step forward. Europe and Greece will emerge stronger from this crisis,” Greek Prime Minister George Papandreou boasted to reporters. Angela Merkel, the German Chancellor, agreed: “I think that it demonstrated Europe’s capability to handle things and at the same time did something for the stability of the euro and for solidarity with a country that is in difficulty.”

President of the EU Commission, Jose Manuel Barroso, then told markets what they should do next: “I hope that financial markets will now act on fact and not on fiction.” And what did markets do? The euro soared against the US dollar, commodities went up on better sentiment, and stock exchanges around the world noted gains.

No, none of this took place last week. It all happened in late March 2010 after one of the earlier summits on the future of Greece and the euro. The statements only sound so familiar because we have heard them after each and every single crisis summit of the past 20 months. There have been no fewer than 14 of them.

It is easy to ridicule European politicians for failing to solve the problems while continually claiming to do so. But what about markets, what about the media? Are they really any better than politicians with their rose-tinted glasses?

Barroso should have been careful with his wish that markets “act on fact not on fiction”. If markets actually did that they would never get themselves into a state of ecstasy whenever European leaders proclaim an end to the continent’s crisis. And yet the ensuing relief rally now belongs to the folklore of crisis meetings like press conferences in the dead of night and undiplomatic exchanges between top EU politicians.

Rapturous market reactions are now just as predictable as the political failures that cause them. Last Monday, three days before the results of the summit, I was interviewed on ABC Radio National about my expectations. My answer was quite cynical: “I can predict that the markets will be enthusiastic and celebrate the great settlement and the final solution to the euro crisis. And then, after two days they will look at the fine print and find out that they actually haven’t decided that much after all. It’s a pattern.” This must have been one of my most accurate forecasts yet.

On Thursday, impressed by all the happy faces in Brussels at 4 am, Germany’s DAX jumped up almost 6 per cent, the FTSE and the Dow Jones Index finished up almost 3 per cent. The Australian’s headline was “Europe steps back from brink of debt crisis”. Germany’s ARD television praised the EU’s decisions as “substantial”, “a success” and proof that Europe’s politicians were doing their jobs properly. Finally, US President Barack Obama personally congratulated his European colleagues on making “important progress on a strategy to restore confidence in European financial markets, laying a critical foundation on which to build.”

But then, just as I had predicted, the surge of euphoria ebbed away as quickly as it had come. Suddenly the details of the Brussels deal appeared.

So Greece got a 50 per cent haircut on its debt? Well, not quite. Only private investors will be affected, and only on a voluntary basis. Loans from the International Monetary Fund, the European Commission and other European governments will be immune from any cuts. This leaves almost half of Greece’s debt untouched.

Even the actual haircut for private investors will not necessarily be the 50 per cent that was announced. As always, it is more complicated because it depends on the maturity of the new Greek bonds to replace the old ones, the interest that is paid on them, and the implicit value of the guarantees given by the EFSF. All these still need to be negotiated.

Holger Schmieding, chief economist at Berenberg Bank, told German newspaper Die Welt that in this way the 50 per cent haircut for the banks could be worth just about 33 per cent. And in the same paper, Christoph Kaserer, professor of financial management at TU Munich, opined that the banks had been quite successful in Brussels at saving their necks. Who could disagree?

However, even if the EU somehow managed to cut Greece’s privately held debt in half, and further assuming that they also get the Greek economy back on a sustainable growth path, the Greek debt-to-GDP ratio would still be 120 per cent in 2020. In other words, the country would still be bankrupt and would have to remain on EU/ECB/IMF life support.

By all measures, the proclaimed solution to the Greek debt problem as announced last Thursday is a scam and it only took two days for the world to notice. On Saturday, The Economist wonderfully summed it up in a cartoon on its cover: From a sinking Titanic Europe’s leadership is ditched in a giant colander.

In similar ways, the other measures announced in Brussels were equally insufficient and lacking detail: Leveraging the EFSF: Yes, but where does the money come from? Recapitalising the banks: Sure, but who would be foolish enough to invest their money in a Greek bank? And above all the question remained unanswered how the enormous macro-economic imbalances within the eurozone should be recalibrated. On this crucial issue, the summit had nothing to say at all.

Any undergraduate economics student looking through the glorious announcements coming out of Brussels could have recognised that they are not a solution but more of the same problem. This begs the question why markets were initially celebrating these non-results nevertheless?

Perhaps market participants (and some journalists) really just want this crisis to be over. After more than two years of eurozone agony this would be more than understandable. Maybe traders run on an autopilot that has not been reprogrammed to distinguish between “smiling faces at news conferences” and “palpable results”? Or is it that you just cannot afford to be realistic in your assessment when everybody else isn’t?

Here we are again, just a week after a supposed breakthrough for Europe, and the crisis is getting worse. First there was the alarming auction of Italian bonds last Friday; then the whole deal reached last week was effectively put on hold by the Greek prime minister on Tuesday. Expect more bad news in coming weeks and months as European growth stalls and ratings agencies will have another look at Italy, Belgium and France.

But don’t despair. On Friday, December 9 there will be another crisis summit in Brussels. Stock markets should be soaring on Monday, December 12. The boom won’t last long though.

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