EMU Breakup Framework

Background

European sovereigns are experiencing financial stress from fiscal deficits and rolling their existing debt.  These issues are worsened as members of the European Monetary Union. The EMU is a common currency shared by 16 of the 27 European Union members, with one more nation to join in 2011.  By being a member of a currency union, an individual nation’s ability to target an exchange rate and interest rate policy appropriate for its point in the business and employment cycle is effectively surrendered.  The nations in Europe having the most problems with their debt are those with low labor productivity, high current account deficits, large financial system debt relative to GDP, or low tax compliance: Greece, Ireland, Portugal, Spain, and Italy.  The other EMU nations and the IMF have combined to create a European Financial Stabilization Fund in order to prevent systemic financial risk.  The EFSF will purchase the debt of the troubled nations for the next 3 years -- unless the private markets come back sooner; both Greece and Ireland have tapped the EFSF for funds so far. 

Scenarios

It is difficult to judge what the various probabilities of outcomes are.  Roubini Global Economics has forecast a 35% chance of some kind of breakdown by the end of 2012, with this risk increasing to 45% by 2020.  Rather than handicapping the odds, the most important takeaway is that it’s not a zero delta any more.  Here are some potential scenarios:

A: Greek Exit

The Greek situation is difficult as their deficit is driven by a large primary budget gap, in addition to a financing gap.  This is analogous to a corporation with a negative operating cash flow, and a poor financial structure.  Financial restructuring can fix a “bad” capital stack, but it cannot make a good business.  Greece is stuck in a similar situation – even if it imposes 50% haircuts on its bondholders – it can not solve its structural deficit problem.  The surplus nations / creditors’ solution to keep extending loans (via EFSF) delays the readjustment in order to buy time for the creditor countries banking system.  The policy prescriptions of austerity, wage deflation, tax hikes, and spending cuts inexorably drive Debt/GDP ratios higher rather than lower, as the economy undergoes a recession.  At some point, the austerity being imposed by outsiders will grow intolerable, as deflation forces most of the adjustment costs onto the domestic economy (and voters) rather than broadly sharing the burden between borrowers and lenders.  At that point, it is reasonable to expect these events: euro withdrawal, currency devaluation, and debt restructuring.  During this upheaval, it is typical for a financial emergency be declared and capital controls imposed.  Given that 90% of Greek debt is governed under local law (unlike Argentina who issued under American & English law) the Greek government has more ability to control the adjustment process, and reduce the damage afterwards from reduced access to markets.  Some market price forecasts

            Bond Haircuts: S&P has suggested recovery rates for bondholders at 30% to 50%

            Currency Adjustment: ING has suggested a “New Drachma” would fall 80% vs. the EUR

            Bond Yields: RGE suggests Bunds go to sub 1% yields while peripheral yields hit 7-12%

            Euro: estimates vary widely but ranges from .85 to 1.15 vs. USD are suggested

           

B: Partial Breakup

The way the EFSF is structured -- as a supranational borrowing fund partially backed by the very same borrowers -- creates a vicious circle as more countries avail themselves of the facility.  Essentially, as the funding lines get drawn on by more member nations, the burden increases on the dwindling number of backers.  Under this domino theory, after the first EMU withdrawal, the contagion will spread quickly to the other peripheral nations, eventually leading to the PIGS nations withdrawing from the EMU, in order to make economic adjustments without the limitations of a monolithic currency and interest rate.  Under this scenario the EMU splits into a hard currency bloc and mostly Mediterranean currencies.  In addition to some of the forecast impacts above, there will be further damage as the European financial sector sees its capital base destroyed.  Government bonds play an important role in depository banking, being both an interest earning asset, as well as the regulatory capital set aside to protect against credit losses.  So when regulatory capital goes bad, it has a particularly crushing effect on the financial sector.  The exposure to PIGS debt ranges from 20% - 40% among the large Western European banks, and the sector still is weak from the 2008-9 financial crisis and recession.

C: Full Dismantling

Under the extreme stress test, northern European nations are unable to agree on a hard currency bloc and, like their neighbors to the south, decide their national interest is best pursued with sole control of their store of value / medium of exchange, and its interest rate.  In this case one could expect wide divergence between end currency values and interest rates.  If one looks at the original rates that each nation entered into the union at, nearly all will suffer devaluation upon exit if an account surplus/deficit model is used.  The valuation adjustment would be borne by Germany who would exit with a currency that was stronger than it entered EMU with -- the product of a decade of surpluses, high productivity, and competitive exports.  However that still may not mean the resurrected DEM is worth more vs. USD compared to its entry value – given how much the EUR will fall as the EMU disintegrates!  Given the massive uncertainty over how currencies might be translated over, one would expect a flight to safety to USD, CHF and possibly NOK / SEK.

First Order Effects

The first order effects will be price shocks to a host of financial instruments both within the EU / EMU and, as the waves ripple outwards, toward other areas.  Based on the scenarios described above, ascribe more severity as the EMU proceeds to fragmentation; less if it’s a single national withdrawal.  Here are some range estimates from research we have reviewed. 

            FX:      

                        Greece – A new drachma could be 80% lower vs. EUR

                        Spain / Portugal / Ireland – Pesetas, Escudos, and Punts could be 50% devalued vs. new DEM

                        Italy – Lira down 25% vs. new DEM

                        France – Franc down 15% vs. new DEM

                        Other core – Benelux, Austria, Finland down 7.5% vs. new DEM

                        Euro – as the crisis deepens, rates from .75-1.15 suggested

                        USD / CHF – Flight to safety currencies, others may be Nordics.

            Recovery Rates:

                        Estimates are recovery rates of 30% to 50% on an NPV basis.

                        Haircuts for bond holders could take the form of

Rescheduled maturity

Principal adjustment

Coupon manipulation.                

            Bond Yields:

                        Wide divergence expected

                                    Northern Core – low rates, with some reaching sub 1% yield

                                    Peripherals – high rates, with worst hitting teen range

            Curve Shape:

                        Money market rates to compress as assets flood into ‘cash’

                        Curve to steepen as risk premium for term money heightens

Second Order Effects

After the immediate price shocks, there will be numerous additional impacts across the economy and markets.  One of the first will be capital controls as governments seek to redenominate assets and liabilities in their country, and stop mobile capital from leaving.  These will be difficult to implement, as having moved to one common currency simply makes it easier for those in troubled nations to move their financial holdings abroad.  Greece and Ireland are already experiencing domestic depositor flight from their banks, so capital controls may come even before EMU unwind.  A second large effect from EMU fragmentation will be the capital destruction in the major European banks.  Despite the small size of most of the peripheral countries, they have issued large amounts of debt, and most of that resides on the balance sheets of the banking system.  (Why? With ECB interest rates at effectively 0% and no longer any limits on collateral quality, European banks are running the carry trade…in size)  Banking systemic distress will be the second powerful knock on effect. As the banking system becomes insolvent (not just illiquid) regulators and legislators will have to make painful choices: does the pain get imposed on the bondholders / equity holders only, or does this risk get socialized?  The track record over the last two years points toward repeating the privatization of gains and the socialization of losses.  As business and consumer confidence are dented from the above, it’s reasonable to think the real economy will suffer as US commerce slowed sharply after the financial crisis crescendo of fall 2008.

Longer Term

Over the longer term, a partial (or full) splintering of the EMU will reduce growth within the EZ.  A common currency made EMU economies more efficient by reducing friction costs and improving planning – that advantage will be reduced if EMU is ended.  That reduction in regional economic growth has been estimated at 1% to 9%, depending on the scale of unwind.  Peripheral countries pulling out will be impacted more.  As debt is destroyed, there are deflationary effects as well, which could spill over to other regions.  In particular, a strengthening USD may hurt US exporters, and tip the US economy back into recession.  Global growth and inflation ought to be lower after EMU unwind.

Case Studies

Here are recent sovereign bailouts/defaults, along with commentary from Bridgewater Associates. 

Bretton Woods Exit: USD devalued against gold, prices moved from $35/oz to $70/oz from 1968 to 1972, essentially a 50% devaluation

Mexico 94: 60% currency devaluation

Thailand 97: 40% devaluation

Indonesia 97: 60% devaluation initially, 90% eventually banking system and external debt restructured.  Hyperinflation

Korea 97: 50% devaluation, but rapid recovery in fx, markets, and growth

Russia 98: 80% devaluation, default

Brazil 98: 40% devaluation

Argentina 01: 65% devaluation, capital controls, default

Hungary 08: 30% devaluation, 10% further later, debt continues to spiral up

Pakistan 08: 25% devaluation, stabilizing

Ukraine 08: 35% devaluation, stabilizing, but not out of woods yet

Iceland 08: ~ 50% devaluation, capital controls, banks insolvent, depositary insurance revoked

One key thing to note, in almost all situations sovereign debt problems are generally not solved with austerity.  Canada and Nordic countries in the 90’s are noticeable outliers in that case, benefiting from global growth and unusual domestic political solidarity in bringing the fiscal house into order.  The majority of times, imbalances are resolved in a way that imposes burdens on creditors: whether its devaluation, restructuring or default.  The EMU takes away some of these options, suggesting that staying within the structure is economically and politically unstable.

The trend within Europe, over 50 years plus, from the first formation of a coal and steel customs union across the Alsace-Lorraine, has been toward deeper integration and harmonization of countries.  This is a powerful trend to buck, and there are good arguments that the current crisis will lead to a “Federal Europe” rather than a schism.  It seems difficult to reconcile that when languages, customs, and ethnicities are so different, even across small regions.  India is a case where a federal system does work (despite the language and customs differences) but note that the state governments there are powerful relative to the central national government.  But I do want to acknowledge that potential policy solution to the problem; RGE assesses a 25% chance of that outcome.

Investment Implications

The impact among European financial equities would be severe, as most financial companies are inherently leveraged, and even small haircuts to asset values can quickly wipe out equity.  Revisiting the market capitalization changes of US financial equities during the 07-09 financial crisis would be instructive to show how quickly even the largest institutions could fall.  Even ‘national champion’ TBTF banks could fall, if the sovereign that implicitly backs them is not large enough to meet claims, or is unwilling to.  In this respect, the impact is not purely analyzable from a spreadsheet / economics perspective, but requires careful thought around the domestic and international politics of the affected nations.  (For example, Latvia which is weathering a crushing austerity program to meet its obligations, and doing so with a resigned societal solidarity.  Why?  To citizenry there, there is the perspective that EMU/EZ/NATO is a package deal, and that failure in one part will lead to a collapse in the other parts.  Having only recently left the Russian sphere of influence, NATO membership is needed as a bulwark against Russian influence, and a shield citizenry are willing to pay a heavy price for)

Milestones to Watch

The value of the Euro, the inter Sovereign CDS spread markets, and the equities / credits of European financials will all be important measures of the real time probabilities of EMU disintegration (in one form or another).

Conclusion

We should consider putting on a portfolio tilt to actively underweight financials.  This is painful, as this sector is already considered cheap by many metrics.  Again, that is a topic for deeper exploration but if history is a guide, financial equities tend to be poor performers when underlying sovereigns credit is deteriorating.

How A Very Large Investor does Risk & Asset Allocation

We met with the risk and asset allocation head at A Very Large Investor today.  

Here were some of their thoughts

• approx 100 bn plan
• 75 year time frame, partially funded, not like a typical gov or private plan
• Currently no net liabilities are due – do not have payouts for another 11 years
• Unusual set up – A Crown Corporation – they can set their own comp/incentives – but have public mission
• (I would posit the above is intrinsically unstable e.g. FNM and FRE)
• 40 people in their Risk/Asset Allocation group
• Economists
• Investment Researchers
• Quants
• Mostly CFAs but the longer term plan is to shift toward PhDs.
• They view assets with equity type risks as Equity, and adjust for beta
• Implication – if they buy 1mm of private equity, it gets a beta forecast (hypothetically 1.3)
• Then to fund that PE purchase they sell 1.3mm of public equity and buy .3mm of fixed income
• This way all investments are considered in respect with a public market risk/return profile
• Real estate for example has typically 3 buckets: .3 beta, .7 beta, 1.1 beta
• Discussions over forecast beta between investing and risk group: risk has final say
• They use Riskmetric somewhat, primarily to get to 1yr VaR numbers
• It seems they basically break the world down into Equity and Govt risks, with even credit being a hybrid of those two
• Somewhat different than us, probably better than our ‘Label Based Investing’ system, but different governance, org structure/system, and participation.
• They do direct investing / coinvesting as well
• No fixed allegiance to a set min or max amount of private asset classes

3 Charts on Risk

These three charts struck me as interesting, given current market / economic conditions.  (They are from GS “Weekly Kickstart” note)

I find it surprising that ‘fear’ has evaporated in the market given the gathering storms in sovereign creditworthiness; whether they are the Mediterranean’s or island nations of Japan, UK or Ireland. The media is quick to cheer that Greece has been ‘saved’ by another bailout (110 billion for a nation of 11 million!), but it’s hard to see the sustainability.  And as an aside, there was chatter out of Europe this wknd that Lazard has been engaged by the Greek govt to look at restructuring.  (Lazard recently handled Ivory Coast and Ecuador’s restructurings)

Again this chart too shows much of the same behavior as the above – people are paying less to be fearful.  Another way I think of VIX -- as not just implied volatility -- but also as a price of liquidity, since options are the right to buy/sell specified amounts at specified prices.  If VIX is low, liquidity is not as dear as it used to be.

The above is US big cap stock centric, but my instinct is that this applicable to other markets/sectors as well.  What does it mean?  The relatively high levels of sector / individual stock correlations suggest that even though we are not in the beta market of 2009, macro market moving events are still driving individual asset prices rather than idiosyncratic behavior.  This seems particularly true of sectors which are being pushed around by sector risks whether Cap & Trade for utilities, Financial Reform for banks, or Health Insurance laws for drugs / insurers.  One other non risk thought -- If this goes lower it’s probably a better for active management but if stays high persistently indexing will look better.