Greece and the future of the single currency

  • French and Greek elections
  • What if Greece leaves the euro?
  • What if Greece stays in the euro?
  • European politics v. European corporate strength
  • Summary

Equity markets around the world, most notably in Europe, suffered sharp falls last week with the financial sector bearing the brunt of the selling pressure. The trigger for the latest sell-off was the news that the European Central Bank (ECB) had suspended its lending to Greek banks at the same time as many depositors were looking to withdraw their money. While long-term investors focus on the underlying corporate strength and see opportunity in market falls, many others become understandably concerned over the immediate impact of these macro geopolitical manoeuvres.

It’s been a long two years since 25 March 2010 when Greece received the first bailout package from the European Union (EU) and the International Monetary Fund (IMF). Much has happened yet little achieved since; but the coming months look crucial for Europe and the future of the single currency. Many member states are in recession and facing strict austerity measures; and recently we have seen governments fall as the people voiced their discontent, adding to the uncertainty of the region’s future.

 

French and Greek elections

Elections were always going to play a key part in the short-term future of the eurozone. The election results appear to show the desire of voters to remain in the eurozone without the accompanying austerity measures. In our view this dual approach is untenable. It is hard to see how any country can remain in the eurozone without a strong commitment to improve its own fiscal position.

Previous leaders in Greece and France who were supportive of the proposed austerity measures have been voted out, prompting talk of re-wording previous agreements. In short, that option is not available. Greece’s choice remains to accept the austerity measures and remain part of the eurozone, or leave the single currency and go it alone. The risk of a disorderly default has dramatically increased after the Greek election, but this is more due to a lack of political cohesion and not necessarily a lack of appetite for the euro. An estimated 75% of Greeks are in favour of Greece retaining the euro. It looks like a compromise needs to be found when, even after this weekend’s G8 summit, there isn’t one on the table.

 

France

François Hollande became France’s first socialist president since the 1980s whilst promising an increase to the minimum wage, the hiring of an extra 60,000 teachers and lowering of the retirement age from 62 to 60. To implement his election rhetoric would cost the country an estimated €20 billion over the next ten years – and that’s only for the changes to the retirement age. Needless to say, France can ill-afford that, certainly not without unwelcome tax rises sooner rather than later and a significant rise in government funding costs. Words are cheap and promises easy on the election trail.

The jury is still out on whether Mr Hollande and Angela Merkel, the German chancellor, will form a strong alliance or mark a post-war low in Franco-German relations. Mr Hollande has pledged to push for less austerity and many other policies that the German chancellor opposes, including delaying the deficit-reduction plans and renegotiating the fiscal treaties signed by all but the UK and the Czech Republic. Mr Hollande is convinced that he can lead a coalition, including Spain, to press for more EU spending, including direct intervention from the European Central Bank. It is unlikely that the new French president can backtrack on election statements this soon, but pressure is growing from all over Europe and firm action is needed urgently. As the days go by, it is clear that ‘muddling through’ is no longer acceptable. This is where the real work begins. The French population voting for a pro-growth candidate is understandable, but in order to work towards some of his softer policies he needs German agreement to keep interest rates low. This is a delicate balancing act as it is not difficult to imagine Angela Merkel’s views on his main election promises.

 

Greece

The situation in Greece is even more concerning. A clear majority of the population voted for parties opposed to the budget cuts imposed by the European Union. No coalition government could be formed, prompting the need for another general election on 17 June. The two main parties that came together last year to implement the austerity programme were severely punished as their total vote was slashed by half. This leaves the two parties that have dominated Greek politics for decades unable to renew their coalition and implement plans for €11.5 billion of fresh cuts at the end of June, as demanded by the EU. The election was the Greeks’ first opportunity to express their views on the terms of the bailout after a planned referendum was cancelled under EU pressure – and the message was clear.

The calls from the radical-left coalition, Syriza, and their leader, Alexis Tsipras, were that Greece should remain in the eurozone with creditors accepting an easing of the bailout conditions. This was music to the ears of hard-pressed Greek citizens. As with France, it is easy to see how the election rhetoric won over uncertain voters.

 

What if Greece leaves the euro?

A Greek exit from the single currency would severely test the firewalls erected by policymakers and put the region’s banking system under extreme stress. The concern for many is the example Greece would set for other struggling nations, creating a precedent should other countries get into such severe trouble.

Given that the majority of Greeks are in favour of staying in the euro, the election result portrays a scene of confusion. As a nation, Greece can’t have it both ways: to stay in, it must accept agreed austerity measures.. The rest of the eurozone has made it clear that leaving the euro will be a Greek decision, with Guido Westerwelle, the German foreign minister, stating recently:

“The future of Greece in the eurozone lies in the hands of Greece. If Greece strays from the agreed path, then the payment of further aid will not be possible.”

There is no precedent for a country leaving the euro and there is no obvious process for doing so.  The trigger for an exit would be the point when the government runs out of money to pay social security and wages. At this point, Athens would need to pass a new currency law, re-denominate all domestic contracts into the new drachma, impose exchange controls and take steps to introduce a new paper currency. Printing and distributing alone would take in excess of three months, judging by the most recent example when Iraq re-issued its currency in 2003. That required the efforts of De La Rue, a British speciality printer, and a squadron of Boeing 747s and armed guards. After exit, Greece would have to renegotiate for continued EU participation, which would be a forlorn hope having defaulted on debt to the ECB, IMF and the European Financial Stability Facility.

In any exit scenario, there is no doubt that the new drachma would depreciate immediately. The markets would dictate the severity of this fall, but the IMF predicts Greece would need a devaluation of at least 20% against the eurozone average, and considerably more against Germany, just to achieve a current account balance. Such devaluation would increase Greek competitiveness, but would have huge legal ramifications with regard to the existing debt owed to Europe and the IMF. According to the latest figures from the IMF, global financial institutions hold €422 billion of sovereign, household and corporate Greek debt. Analysts profess that the total losses could reach €66.4 billion for France and €89.8 billion for Germany. Were the new drachma to depreciate by as much as 50% against the euro, the losses for French and German banks alone could reach €19.8 billion and €4.5 billion respectively.

Economists predict that if Greece was no longer part of the single currency, it would lose a further 20% of GDP on top of the 15% decline already experienced. The external impact of such a recession should be minor as Greece represents only 2% of European GDP, but the dangers lie within capital flows, which are the biggest unknown at this point. If eurozone authorities could convince investors and the public that Greece is a special case, the effects of an exit could be contained. If not, then the inevitable question would be “Who’s next?” Take Portugal as an example, which followed Greece by accepting a bailout package. Investors could sell Portuguese bonds, seek to extract money from the banking system and take their euros overseas, amid panic over a possible exit from the euro and subsequent devaluation. This is the contagion fear expressed by many commentators.

If the political will to hold the eurozone together exists, and we believe the will is strong, there is the option of increased action by the ECB. It could restart bond-buying at very high levels, limiting rises in bond yields, and offer unlimited liquidity to peripheral nations’ banks. Unlimited ECB action could also lead to a fiscal union being declared, involving transfers from the strongest countries to the weakest. This would worry Germany, which feels the ECB has already gone too far in underwriting bank and sovereign debt. However, the alternative is worse as the EU has no sufficiently powerful defence against a bank run in stricken nations. Concerted action by the eurozone could limit contagion, but that result is highly uncertain and, if it did not work, there is no other way to go at that point other than a break-up of the euro.

In either case, the outlook is risky. After the Lehman collapse in 2008, it was not the lack of bank lending that plunged the region into recession, but the collapse in household and corporate spending. The public needs to be convinced that whatever course of action is taken is the right one, and this is as big a challenge as any.

 

What if Greece stays in the euro?

If Greece decides to remain in the euro, something has to give. This must be the Greek acceptance of the bailout conditions, perhaps with German flexibility in administering the medicine. Despite apparent steadfastness, Angela Merkel has already shifted several times during the crisis, always at the last minute. She hinted at another shift this week:

“If Greece believes that we can find more stimulus in Europe in addition to the memorandum, then we have to talk about that.”

Relaxing the timetable for Greece’s deficit reduction and budget cuts could help, allowing the economy to breathe a little rather than being strangled while in the depths of recession. The same could be said for Spain, or even the Netherlands which, despite a strong economy, continues to battle a deficit that would be more easily repaired over four years rather than two. The right-wing Spanish government has committed to cut spending and make the structural changes necessary to meet eurozone targets. But Spain has a major issue with Greece, fearing that it is next in line for the financial markets. Politically, Madrid is angry that Berlin and Paris are failing to fix the euro, leaving Spain highly vulnerable to events outside its immediate control.

Jeremy Warner, chief economic editor at the Sunday Telegraph, commented, “It’s long been apparent what needs to be done to save the euro. The debt has to be fully mutualised through the issue of eurobonds, the ECB needs to start acting like a lender of last resort and Germany has to accept a higher rate of inflation. By becoming less competitive itself, Germany can help the peripheral nations to become more so. This has always been a political project rather than an economic one, and Angela Merkel insists that she’ll do whatever it takes to save Europe’s destiny.”

“Is Germany really prepared to bankroll a wider monetary union by putting its money where its mouth is? We may not have to wait too long to find out.”

Wednesday sees a special EU summit in Brussels, the results of which should tell a lot about the immediate future of European politics. Greater flexibility and longer timelines for debt reduction will allow Alexis Tsipras to claim a victory in his ‘renegotiation’ of Greece’s rescue and the new French regime would declare itself to be already making a difference with a pro-growth agenda. However, the Germans are likely to stress that austerity remains sacrosanct. Reports this morning suggest pressure is mounting on Angela Merkel and that François Hollande has found powerful allies in José Manuel Barroso, president of the European Commission, and Mario Monti, the Italian prime minister. Another controversial measure back on the agenda will be unlimited purchasing of Spanish and Italian bonds, an idea opposed by Germany but becoming increasingly popular among other eurozone nations.

 

European politics v. European corporate strength

While it is impossible to predict short-term market fluctuations and ignore politics entirely, many European companies are thriving and deriving income from all over the globe. Very few leading European businesses are domestically reliant nowadays, and derive more of their profits from the US and emerging world. German manufacturing is just one example of a thriving sector, helped by a weak euro, enabling European companies to make significant market-share gains. For investors with a long-term view, valuations look cheap and European equities should form part of any diversified growth portfolio. Stuart Mitchell, manager of the St. James’s Place Continental European fund, commented:

“Company earnings should increase by 10% in 2012, the same figure as in 2011. In the first quarter alone, earnings increased by 4%. The weakness of the euro is helping exporters, and therefore economies such as Germany. Scandinavian economies are rising by 3-4% per year, which are the kind of figures most countries would dream of. More than 50% of European consumption comes from Germany, Switzerland and Scandinavia, and these economies are thriving.”

Specifically with regard to company valuations, Stuart observed:

“US consumer spending is at its highest level for years, more than 5% higher than in 2007 when everything was thriving. Any European company at the head of its industry and reliant upon US demand is in prime position, trading at a discount solely because of its regional listing. European companies are trading at 50% discounts to their US competitors based simply on where they are located.”

Of course, uncertainty is what the markets like least but equity prices are a claim on future earnings. As we have always stated, this will be a long road to recovery and there is likely to be many more political problems to solve. It is clear that volatile markets are here to stay. Long-term investors need to step aside from the media headlines and focus on the global news at a company level which, on the whole, continues to surprise on the upside. While it is impossible to predict short-term market fluctuations and ignore politics entirely, many, if not most, European companies are thriving.

That said, amid the equity volatility over the last three months, what might be overlooked is that other asset classes have held up relatively well. This wasn’t the case in 2008 when asset classes were highly correlated and bonds, property and equities all saw sharp falls. As the chart shows, UK, Europe and emerging markets have fallen sharply over the last three months, although US equities have shown greater resilience, reflecting an improving growth outlook. Gilts, corporate bonds and commercial property have held up, continuing the trend seen for most of the last 18 months. In normal market conditions, diversification across asset class and geographical region remains the essential tool to reduce volatility within any investor’s portfolio. We have always advised clients to hold any short-term liquidity funds in cash to enable them to take a longer-term view with their growth assets. It is impossible to predict short-term fluctuations, especially when these movements are based on sentiment and political wrangling, but volatility does not need to be feared by a long-term investor.

 

Performance by asset class 18/02/2012–18/05/2012

Source: Bloomberg. Past performance is not indicative of future performance

 

Summary

It is unclear whether Greece will leave the eurozone, either voluntarily or by being pushed, but in politics things change very quickly. Politicians are hearing what the people want and this is driving policy in the peripheral nations. However, the problem will not go away overnight and will take years to resolve. Stronger economic growth would solve a lot of problems but that is difficult to see in the medium term. If the single currency is to survive, it seems certain that Germany must push through greater fiscal union and the issue of eurobonds, probably before their own elections in the autumn of 2013. The idea of eurobonds, where debt would be underwritten by all 17 countries that use the currency, has always been resisted by Mrs Merkel, who sees them as a short-term step to Germany bankrolling the irresponsibility of others. However, now appears the time to consider such options. Anything other than action on these issues runs the risk of repeated market panic, but it will take time to convince the voter base that it is in their interests. Our view is that the risk of disorderly eurozone collapse is small although Greece may well revert back to the drachma. Ultimately a solution will be found. Amongst the main players in the eurozone, the willingness and need for the euro to succeed should not be underestimated.

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