Courtesy of our good friends from Rcube Global Macro Research, please find enclosed their recent note on the Euro and its "Third Snake in The Tunnel".
In exchange for being bailed out, PIIGS countries have to apply harsh austerity measures internally, under the authority of the “Troika”. In a way, they have been demoted to developing countries original sinners, indebted in a currency that is not theirs to print.
For both political and economic reasons, this system of conditional bailouts is not a viable solution in the long term. This is evidenced by the fact that countries that benefited from a bailout are still trading above the 600bp tunnel limit.
For the Euro to survive in the long term, we believe that large explicit transfers of wealth between creditor and debtor nations will be necessary at some point. Regardless of the term used, the European Union will have to morph into a de‐facto “federation”.
The feasibility of a federal Europe
In his September 2012 State of the Union address, José Manuel Barroso, the European Commission President, proposed to transform the EU into a “federation of nation states”, with preliminary discussions starting before the 2014 European elections.
In early October, EU’s President, Herman Van Rompuy made the case for a Eurozone central treasury, which would have its own budget and be able to raise funds.
Although these proposals havenft sparked enthusiasm, we believe that moves towards a federal Europe will be the only way to avoid the next leg of Euro crisis to be fatal.
In fact, some of the most ardent supporters of a federal Europe have always considered the Euro as a way to force deeper integration. The current debt crisis is the perfect setup to promote integration, because it forces countries to create a gcommon beasth to feed.
In economic terms, the countries with the most to lose in a federal solution are the creditor countries, which are generally also the ones with the highest GDP per inhabitant (Ireland being the exception). What follows is a back-of-the-envelope calculation of what a federal Europe would imply in terms of permanent wealth transfer for these countries.
Right now, the European gfederal budgeth represents a tiny percent of EU's GDP, with around half of that devoted to the Common Agricultural Policy.
In the US, Federal outlays represent around 22% of US GDP.
As a thought experiment, we can imagine a Eurozone federal budget that represents 20% of the Eurozone's GDP in the long term (the federal budget would probably only concern Eurozone members, because applying it throughout the EU would require a preliminary "Brixit"). Like in the US, the federal budget for the Eurozone would cover military expenses, a large part of social expenses, infrastructure, and so on. Some of the funds would be spread according to each countryfs population (e.g. military expenses), while others would be more heavily skewed towards poorer countries (e.g. social expenses).
Conservatively, we can estimate that richer EZ countries would have to give up around 30% of the difference between their own GDP per inhabitant and EZfs average.
The current ranking of EZ countries by GNP per head of population is shown below:
Roughly speaking, countries in the richest group would have to reduce their living standards by between 5 and 7% if the EU was to transform into a European federation (we ignored Luxembourg, which is a clear outlier at 244% of the average GDP per head).
At first glance, this does not look like a huge sacrifice to save Europe, especially if these adjustments are spread over the next 10-20 years.
However, when we look at growing divides within countries such as Italy, Spain or Belgium, national solidarity (let alone European solidarity) does not seem to be the course of history.
At the risk of sounding like parrots, we maintain that the Euro is a purely political construct, and therefore depends on politiciansf (and ultimately voters') views of their best interest. If growth rates remain anemic in Europe, it will be politically very difficult to add a new gbeasth to feed.
Right now, PIIGS' sovereign spreads still indicate large implied breakup probabilities over the next 10 years. With a 10 year yield spread of around 350bp for Italy and assuming a potential 50% devaluation, the implied exit probability for Italy is around 50% over the next 10 years (for more on this subject, see Rcube Macro Analytics 18 01 2012 - The likelihood of a Euro Breakup).
In our view, spreads should continue to tighten in the coming months, as politicians still show strong willingness to accept any compromise to maintain the system - even in the case of Greece, which should soon receive an extra . 30 Billion despite its lack of progress in putting its own house in order.
At the same time, as long as Europe does not clear steps towards becoming a Mundellian "Optimum Currency Area", we do not consider that Italy's or Spain's bonds are suitable carry investments, especially for the longer part of their curve. To paraphrase JP Morgan when asked what the stock market would do, we believe that Eurozone spreads will continue to fluctuate."
We could not agree more with our friends from Rcube.