Tuesday, September 27, 2011

Europe has no way out

I have been thinking extensively about what possible solutions to the European problems. In this post I outline my best case scenario, but as I see it the Europe that emerges out of the financial wreckage is crippled for years to come.

My best case scenario is similar to the plan outlined in the Telegraph over the weekend, though without the leverage. As an aside, the latest news out of Germany where the head of the constitutional court have said that a levered (and possibly even an unlevered EFSF) is out without a referendum is going to be bad news for investors who are looking for a speedy approval of the German EFSF contribution. Notwithstanding that shocker, here are the key elements of my scenario, which does not necessarily depend on the rulings of the constitutional court:
  • Greece undergoes an orderly default sometime in the near future.
  • In the meantime, the EU and ECB cooperate to keep things together. The EU dispenses the next round of aid to Greece and the ECB supplies all the necessary liquidity to the banking system so that the markets don't panic and cause a bank run.
  • On the fateful day of Greek default, many European banks will be rendered insolvent.
  • EU governments implement the Swedish solution and nationalize most of the European banking system. They will tell the banks, "We know that you are insolvent but we stand ready to backstop you and inject sufficient equity to recapitalize you. If you take our option, then the shareholders will get diluted to virtually zero and bondholders will have to take haircuts. Management will get replaced. No depositor funds will get lost. This plan is not mandatory. You may find a private market solution before coming to us if you wish."
  • The cost of this plan is not insurmountable. I had estimated (see analysis here) that an upper bound for re-capitalizing eurozone banks to be in the order of  €700-800 billion. Not all banks will need re-capitalization nor do they all need all of their Tier 1 capital replaced, so the current size of the EFSF may be sufficiently large for such an operation.
A lot of people will get hurt, but Europe will emerge out of this crisis with a much healthier banking system going forward - as all the bad loans will have been written off and we start with a clean slate.

Greece in or out?
Since my best case scenario is similar to the one outlined in the Telegraph article but without the leverage, I felt compelled to explore it some more. The key question in my scenario is, "Does Greece stay in the euro?"

The Telegraph article answers that question:
As quid pro quo for an enhanced bail-out, the Germans are understood to be demanding a managed default by Greece but for the country to remain within the eurozone. Under the plan, private sector creditors would bear a loss of as much as 50pc – more than double the 21pc proposal currently on the table. A new bail-out programme would then be devised for Greece.
If Greece stays in, then what happens after the re-structuring? John Hempton sketched out a reasonably credible scenario for Greece after a default if she stayed in the eurozone:
Greece has a huge problem after the default - which is that its banks are insolvent. They own a whole lot of Greek Paper. Moreover Hellenic Telecom does not look that great either. [Ed: problem solved as insolvent banks are recapitalized.]
The recession goes from bad to worse and the government deficit goes from bad to worse. The Germans wind up owning the banks and the telephone company as partial offset to their losses lending to them. The Greek Institutions are captured by the Germans. (All your base are belong to us.)
They also wind up getting paid a little more as Greek austerity - as long as it lasts and that might be a long time - partially reduces German losses but at huge social costs.

The Eurozone becomes really dysfunctional - with the whole periphery totally unable to work their way out and having lost all their key institutions to the Germans who neither know how to run them nor really want them.

Moreover Greece stays expensive and unproductive and becomes more socially fractious. The likelihood of them staying the the Eurozone would be pretty low. (After all what have the Germans ever done for me!)

Europe would be held together by a massive and compulsory German aid budget. If they can't get that agreed on on day dot (and Merkel and the German constitutional court are not of that mind) then my guess is that is is in Greece's interest to go the Argentine route and let the rest of Europe fend for themselves.

The endgame is still ugly
What Hempton is in effect saying, "Is the Greek economy sustainable after the re-structuring?"

Let's do some back of the envelope calculations here. Supposing that Greek debtholders take a 50% haircut (as envisaged by the Telegraph article) and debt-to-GDP goes from the 140-180% range to 70-90% range. Since they defaulted, they will have to pay a premium interest rate over Bunds - say 200-300 bps. This puts their adjusted debt-to-GDP in the 80-110% area on a German-equivalent basis. This assumes that Greece will undertake the insanely draconian austerity programs currently imposed by the Troika that are already highly unpopular and politically unpalatable.

Here are some unanswered questions:
  1. Where will future Greek growth come from?
  2. Will this life of "living dead" encourage future Greek governments, or possibly the Greek military, to do an Argentina and leave the euro? (Also see Hempton's post on Greece's Argentina option and how the contagion spreads to the other periphery countries.)
  3. Is this another version of kicking the can down the road for the next generation of European politicians?
  4. How will the population of the other periphery countries react to this deal?
While an imminent crisis is averted, there seems to be no good way out of this for Europe.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

No comments: