Tuesday, 27 September 2011

Could the markets have got it wrong?

It is a dangerous game to say that the markets are wrong. As JM Keynes noted: The market can stay irrational longer than you can stay solvent.

Nevertheless, there are some elements of the developments in the last week that are worth a comment.

We have heard US Secretary of the Treasury Geithner tell us that Europe is acting too slowly and that we have to act in order to avoid a disaster. We have read tons of analyses of the Eurozone debt problem, built on dubious assumptions. And we have seen economists who 3 short months ago trumpeted a return to strong growth re-brand themselves as doomsday prophets. 

The underlying economic situation is serious, but not because of the issues that are now driving the crescendo. The Western World has over the past years built a mountain of debt which is clearly unsustainable. The main culprits are the private households who in line with falling interest rates have leveraged themselves harder and harder, mainly in the property market.

Public sectors have “taken over” some of the debt during the first phase of the Great Contraction in 2009 and 2010. Countries with a weak budget discipline have been pushed in the direction of something quite unsustainable. This affects primarily the US and in second line, the UK.

The historically high Debt/GDP ratio will slowly be reduced in the coming decade. As the banks are the pivot in the debt explosion – no banks, no loans – a deleveraging will automatic lead to a shrinking of the banks’ balances. This process is progressing, but is slipping under the radar of the financial markets.

Instead, the markets are busy with something as relatively unimportant as Greece. Government after government has been lying about the real economic situation, and Greece now faces a default. It appears that the Eurozone is about to arrive at a solution that will allow an orderly default, assuming a 50-66% haircut.

This would imply a loss for (European) banks up to €130bn. A large amount, but not impossible to handle. The data released in relation to the European “stress” test showed that a default of this magnitude is possible to control.

Then we have Portugal and Ireland, which at this moment in time do not finance themselves in the open markets. They work to reduce their government deficits. Ireland has progressed nicely and is ready to try a fresh bond issue some time in 2012. There are no reason to expect that these two countries should default on their loans.

Spain is frequently mentioned, even if the country has a relatively low government debt, and a government deficit lower than those of the USA and the UK.

Italy has a government debt of some 120% of GDP, the same as 10 years ago. Reforms have been introduced that will reduce the government deficit to acceptable levels over the coming two years. There will be a significant surplus on the primary budget balance, ie. before interest payments on the existing debt.

There is hardly any reason to believe that Spain or Italy should default on their debt. However, the panic in the financial markets has reached levels that probably requires that EU provides sufficient credit facilities that both countries for a while could cover their financing needs without tapping the markets. This is not a situation based on facts, but on panic.

Then there is the interbank market. The diffuse fears of losses in the European banks have led to a freeze in the interbank market. Central banks have reacted correctly and provide liquidity in order to avoid a replay of the Lehman collapse. A further deterioration of the situation  will not come from this source.

All in all it is a complicated situation where several stories are playing out on different levels. Stock and commodities markets have reacted with a huge increase in risk averseness. A quite understandable reaction, but not particularly logical, given the facts.

But what will happen once Greece has defaulted and the European credit facilities have been increased X-fold?

Then we can return to the really ugly story, namely that OECD needs to bring the debt situation under control. As I have written before, this will imply an extended period of sub-par growth and shrinking bank balances. This problem is not isolated to Europe.

The good news is that even in such a situation, it will be possible to have well functioning markets. The bank sector, however, will see no solution to its problems with the capital base as well as with bad loans.

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