Sunday, 11 November 2012

Guest post - Europe's Third "Snake in the Tunnel"

"The world of men is dreaming, it has gone mad in its sleep, and a snake is strangling it, but it can't wake up." - David Herbert Lawrence, English writer.

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".

"During the past few weeks, the global markets’ spotlight has moved from Europe back to its usual US focus, concentrating on US companies’ results and on the effects of the coming “fiscal cliff”. In Europe, as cans were kicked and bazookas were loaded, the “muddle‐through” scenario that we referred to in our previous Eurozone papers1 is now back on track. That said, like most observers, we believe that the Euro crisis is far from over.

Let’s first look at the Euro from a historical perspective and reminisce about the system that led to its creation: the “snake in the tunnel”. 

The “snake in the tunnel” was the mechanism that European Economic Community (EEC) members used in an attempt to limit currency volatility after the collapse of the Bretton Woods system in 1971. The “tunnel” consisted of bands of 2.25% up and down, inside which currencies were allowed to trade (in other words, currencies were allowed to lose 4.5% against the Deutsche Mark, the strongest currency). The system started in April 1972 with 9 members (the six EEC founders and three soon to be members). The UK left the tunnel in June of the same year, Italy in January 1973 and France in 1974 (it later rejoined and left again in 1976). By 1977, only Benelux and Denmark were left in the tunnel with Germany. Even for those who remained, tunnel limits had to be adjusted a few times because of the strength of the DEM.

In 1979, the system was resurrected with a more appealing name: the “European Monetary System” (EMS). Tunnel limits were readjusted regularly during the early eighties. By the mid‐eighties, disinflationary policies throughout Europe finally brought semblance of stability to European currencies (see graph below):

However, by the early 1990s, the system had failed again: in 1992, after only two years of membership, the UK left (soon after “Black Wednesday”), and Italy followed in 1993. Although Germany’s insistence at keeping interest rates high following its reunification was blamed for the failure of the EMS (it was already Germany’s fault!), any other large asymmetric shock would have resulted in the same outcome. 

After two failed attempts in their battle against volatility, as “third time’s a charm”, European politicians decided to up the ante. In the Maastricht Treaty, they decided to eliminate currency volatility once and for all by simply eliminating individual currencies themselves. The Euro would be an irreversible solution, because no provision would be made to facilitate the return of national currencies. For the general public, the single currency would simplify their lives when travelling within Europe (and save them money in exchange fees). 

As we know in retrospect, the first ten years of the common currency (and common rates curve) led to huge bubbles and malinvestment in PIIGS countries – on government debt, private debt, wage inflation, and so on. 

Had the PIIGS countries kept control of their currencies, they would have been able to monetize part of their debt in the face of the crisis that ensued (like most central banks currently do not refrain from doing). Additionally, letting their currencies slide would have helped them regain competitiveness. 

Instead, market adjustments had to be made in other ways, and volatility, the politicians’ nemesis, reared its ugly head and found a new habitat: government debt yields.

With the Euro, we therefore now have a third “snake in the tunnel”. Instead of central banks trying to defend their currencies, various entities (ECB / IMF / ESM / EFSF and so on) intervene whenever a Eurozone member’s sovereign spread breaches an unofficial threshold of around 600 bps against Germany.

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 havenft 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 beasth 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 budgeth 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 countryfs 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 EZfs 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 politiciansf (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 gbeasth 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.

"And for love’s sake, each mistake, ah, you forgave 
And soon both of us learned to trust 
Not run away, it was no time to play
We build it up and build it up and build it up

And now it’s solid 
Solid as a rock " - Solid, Ashford and Simpson lyrics

 Stay tuned!

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