Europe: Financial Stability Being Tested | Financial Advisors NY

Europe: Financial Stability Being Tested

By: Steven M. Roge, CMFC

Four years after breaking out, the crisis continues to weigh heavily on the fundamentals of Europe. However, the region is still heterogeneous in terms of risks and growth perspectives. Among its members it includes countries that have reabsorbed their external imbalances (the Baltics), countries that have accumulated them during the crisis (Turkey) or those who slowly reduce them (Bulgaria and Romania). Growth models also differ, driven by exports in Hungary and the Czech Republic, by domestic demand in Poland and Turkey, and linked to the evolution of commodities in Russia.

While these growth models are very different, they could all suffer from a resurgence of the 2008 banking crisis, which would have devastating consequences: Worsening of the financial crisis, collapse in global trade, and a credit crunch. For the moment we do not retain this hypothesis and we expect a soft landing in the region. The growth would be therefore close to 2% in 2012 after 3% this year. But such a crisis scenario cannot be completely ruled out.

Limitations
The future of euro is the result of restraints placed on it in the present. Europe with significant debt levels and unbalanced growth experiences a shock that can be healed. Lowering interest rates would lead to currency depreciation or exports becoming cheaper. The recalibration of monetary policy helps narrow a country’s current account gap, rebalance the economy, and promote economic growth. Spending cuts and tax increases can reduce the government’s overall fiscal burden and renew investor confidence toward government actions. However, the excessive debt problem cannot be solved because the threshold will be hit beyond which the economic growth may hinder.

Therefore, the current crisis has limited the number of tools that Economic Monetary Union (EMU) member countries can use. Indeed, as part of the Maastricht Treaty signed in 1992, EMU member countries agreed not only to give up national currencies (for the euro), but also to cede national central bank monetary policy powers to the ECB. Thus, EMU countries that experience acute economic problems essentially find themselves caught in a “policy straightjacket” solely reliant on fiscal tools without remedy to traditional monetary policy tools to weather the economic storm.

After a rebound, the initial GDP estimates for Q2 2011 confirm the activity slowdown in Emerging Europe. However, the situation varies greatly from one country to another. The Baltic countries and Poland are maintaining their solid trajectory; growth is decelerating in Russia, Turkey and Central Europe; while Bulgaria and Romania are having a hard time emerging from the crisis. However, all countries are being hardly hit by the current financial instability. Currencies strongly depreciated during the summer. Floating currencies lost on average 4.4%, with a special mention for the Turkish lira, which lost almost 7.5% in three months to the euro.

Greece And Ireland
Ireland is a country that faced historically high debt levels as government backstopped insolvent national banks and implemented fiscal cuts. Although the Irish government proposed $6bn in spending reduction for 2011, these cuts were only a fraction of the roughly $20bn in cuts needed to reduce Ireland’s deficit to the 3% threshold mandated by the Maastricht Treaty – a goal Ireland hopes to reach by 2014. The Greek government faces more severe difficulties relying on fiscal policy to restructure the economy as the main economic problems are more structural in nature. Economic growth has plummeted with attendant cuts in spending, calling into question the country’s economic viability.

Not everyone Is affected

On the other hand, the Polish economy, which is less dependent on exports than its regional peers (with a degree of openness of its economy of just 38.9), has not yet felt the brunt of the global economic slowdown. Poland’s economy expanded by 4.3% Y/Y in Q2. While the contribution of foreign trade to Polish GDP remains neutral, domestic demand is the only driver of Polish growth. Poland will continue to benefit from the dynamic of its domestic market.

While Latvia surprised with a rebound in growth in Q2 (5.3% Y/Y vs. 3.5% in Q1), Lithuania continues to enjoy sustained growth (5.9% Y/Y in Q2 vs. 6.8% in Q1). Weak household lending in both countries (-14.8% and -4.9% Y/Y in July, respectively in Lithuania and Latvia) remains a significant risk to the dynamic of domestic demand, which had long been the main driver of growth.
Unemployment continues to fall but the levels are still high (12.6% in Latvia and 15.6% in Lithuania in June). After the bursting of the real-estate bubble, the two Baltic countries have absorbed their external imbalances. They are now showing current account surpluses and have reduced their foreign debt by about 16 points of GDP on average since 2009. As a result, growth in Latvia and Lithuania is likely to oscillate around 2.6% and 2.9%, respectively, in 2012.

Growth components are identical to the previous quarter, with domestic demand as the only driver of the economy and responsible for all growth during the quarter. Domestic demand remains robust, thanks mainly to continued strong investment since Q1 (7.8% Y/Y in Q2 after 6% in Q1). Investment is still being sustained by the increase in corporate lending (9.1% Y/Y in July). However, the shrinking of order books and worsening in economic sentiment could limit its upside potential toward the end of the year.

Solutions
A “voluntary” restructuring that involves changing existing investors’ terms of investment through maturity extension would benefit indebted countries. Although, credit agencies have argued that any restructuring leading to lesser return to investors is effectively a default. This is a policy preference of larger EMU members with high Greek debt. Some have proposed issuance of “Brady Bonds,” reduction of debt in exchange for issuance of new debt. While this may be a short term solution, the long term difficulty would still persist.

In absence of an agreement to draw a line under existing debt, remaining solutions to the crisis focus on a potential breakup of the EMU. It must be stated at the outset that there is no robust legal framework or precedent to manage a country’s exit from either the EMU or the EU. Thus, the prevailing assumption will be a member country’s exit based on a negotiated settlement among all member countries rather than a unilateral withdrawal or mandated expulsion.

While the future of euro is still wobbly, its stakes in the current crisis is high and can also impact the global economy. Although it is often assumed that European countries will play the definitive role in deciding the fate of laggard economies, the IMF, United States and China have already pledged key economic and fiscal support to affected countries that suggests a post of stability in the storm. Thus since one school of thought believes financial crisis will will ultimately be the undoing of the EU, other observers see the important influence of inertia and political pride behind maintaining the “European project.”

Investing In The Collapse
Investors may think a euro collapse is strictly a risk to their investments. But the fallout in Europe could also offer the biggest investment opportunity in 2011. Either way, the events as they unfold command attention and respect. The global economic crisis is far from being the “contained” event most global officials thought it would be back in 2008. At one point there were over 60 countries simultaneously in recession. So clearly the “Great Recession” has affected everyone worldwide.
So it’s safe to expect the shocks and crisis to continue. Yet it is possible to avoid the damage and capitalize on the opportunities. With the advent of exchange traded funds, it’s easier than ever to take advantage of this opportunity – or to hedge against the outcome if one has existing exposure to the euro.

One could consider shorting the CurrencyShares Euro Trust (FXE) or buy the ProShares UltraShort Euro (EUO), an ETF designed to rise 2% for every 1% decline in the euro.

Disclosure: I am long EUO.

Additional disclosure: This discussion is for informational purposes and should not be taken as a recommendation to purchase any individual securities. Information within this discussion and investment determination of the author may change due to changes in investment strategy when warranted by changing market conditions, or if a security’s underlying fundamentals or valuation measures change. There is no guarantee that, should market conditions repeat, this security will perform in the same way in the future. There is no guarantee that the opinions expressed herein will be valid beyond the date of this presentation. There can be no assurance that the author will continue to hold this position in companies described herein, and may change any of his position at any time. We use or best efforts to obtain good data in our models, however it can’t be guaranteed that our inputs and data are correct. This is not a recommendation for readers to purchase shares in the above security without consulting your financial professional to discuss your own risk tolerance and objectives.

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