Komal Sri-Kumar
Senior Fellow; President, Sri-Kumar Global Strategies
Asia and California and Capital Markets and Europe and Finance and Global Economy and Public Policy and U.S. Economy
Dr. Komal Sri-Kumar is president of Santa Monica-based Sri-Kumar Global Strategies, Inc., a macroeconomic consulting firm that advises multinational firms and sovereign wealth funds on global risk and opportunities.
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Europe crisis: Not over yet!
By: Komal Sri-Kumar
December 13, 2011
Depending on how closely you keep count, on Friday European leaders completed their 14th or 15th crisis-related "summit" meeting since the beginning of 2010. Fitting a pattern, the results were termed a success by the leaders. Germany's Finance Minister Wolfgang Schauble told the Munich-based Focus magazine that he was certain that the leaders "will be able to handle the debt crisis in Europe with the agreed, far-reaching measures on institutional reform of the European currency union." A close examination of factors behind the agreement suggests, however, that the decisions may end up being another band-aid solution to the still festering crisis. No matter how hard we try to avoid the trite phrase, the imagery yet again is one of "kicking the can down the road." Financial Times' John Authers wondered Saturday if the deal will even get us through to Christmas, and concludes that it probably will not.

Why the doubt despite the hoopla surrounding the all-night negotiations Thursday in Brussels by the European leaders, followed by the early morning announcement of "success?" Let us count the ways.

1. It is an inter-government agreement rather than a treaty change: The decision by U.K. Prime Minister David Cameron to veto the deal meant that German Chancellor Angela Merkel and French President Nicolas Sarkozy could not implement a change in the treaty covering the European Union nations. Mr. Cameron was concerned that submitting to pan-European financial regulations, and the imposition of a financial transaction tax as the German and French leaders had demanded, could seriously harm London's status as a financial center. And he had little room to maneuver given the reality of his Conservative party politics.

2. Penalties for violation could be no more than a slap on the wrist: Eurozone members have a history of exceeding limits on the size of the fiscal deficit (even Germany and France); using derivatives to hide the true size of the public debt (several countries); and outright falsification of data (Greece). While the governments will be required to pay a penalty if they exceed the annual fiscal deficit limit, for example, past experience suggests that the fines will not be large enough to deter governments from boosting spending for purely domestic political reasons. Wouldn't you continue to speed on the freeways if the traffic ticket were just a nominal sum?

3. Even Germany and France have not set a good example: Analysts skeptical that the latest agreements will work can point to lessons learned from 2003. That year, both Germany and France exceeded the Maastricht treaty limit on the fiscal deficit of 3% of GDP (see chart), but their dominant position in the Eurozone enabled them to avoid any serious sanctions. And deficits in both countries continue to be above the 3% mark since the financial crisis of 2008. There is nothing in the terms agreed on Friday to preclude a repeat of the past record of fiscal excesses.

Requirements for an effective, sustained solution
While global equity markets were relieved that Eurozone countries arrived at some type of agreement at the end of their deliberations last week, the fixed income markets continued to exhibit concern. Italian and Spanish ten-year bond yields showed little impact of the decisions taken in Brussels, and yields were higher on Friday than they had been at the beginning of the week. Having spiked up Thursday following the statement by ECB President Mario Draghi that the central bank was not going to increase purchases of bonds to stabilize yields, yields did not come down markedly the next day based on the Eurozone members' promise of greater austerity in the years to come.

4. Member nations to have 20 years to lower debt loads: Even if we assume full compliance, the likely year-to-year reductions in the fiscal deficit and the debt-GDP ratio are likely to be too small to significantly lower the countries' borrowing requirements in the next few years. To ease the adjustment burden and to bring 26 of the 27 EU nations on board, they have been offered 20 years to make the adjustment. The proposed pace of adjustment will likely disappoint financial markets.

5. Firewalls under attack through potential rating downgrades: European leaders began deliberations after Standard & Poor's threatened Monday to downgrade most Eurozone sovereigns -- including Germany -- if a satisfactory resolution was not reached. The rating agency also said Tuesday that it was considering downgrading the European Financial Stability Facility by one, or even two, notches from its current AAA status. The EFSF has been trading at wide spreads to the German bund for weeks. With no comprehensive treaty change arrived at, no commitment by the European Central Bank toward massive sovereign bond purchases, and a possible increase of just €200 billion in the lendable resources of the International Monetary Fund -- not sufficient even to meet the 2012 rollover requirements of Italy -- the decisions Friday will not calm concerns about potential downgrades.

European bond investors appear to have concluded that countries such as Greece with a 160% debt-to-GDP ratio, and Italy not far behind at 120%, have a solvency problem. If that is the case, the cure, viz., an end of the debt problems and the resumption of economic growth, would call for a reduction in the level of debt and debt service. This can be achieved in one, or both, of two ways. First, haircuts imposed even on lenders to countries other than Greece would help lower debt to levels that can be serviced without sacrificing economic growth. This would imply losses to creditors because of the write-downs they would have to take. The initial impact would lower debt service costs while the rise in expectations for inflation would reduce the real burden of debt. Here, since Eurozone banks are able to borrow from the ECB at rates far lower than the sovereign can in the bond markets, the banks will likely be forced to lend to their own governments -- a process known as "financial repression." Lenders will also bear the loss in the real value of the loans they made as a result of any decision by Europe to inflate its way out of the debt crisis.

Whichever path is ultimately adopted, its implementation should be the green light investors should look for before they jump into European equity markets with both feet.

Komal S. Sri-Kumar, a senior fellow at the Milken Institute, is chief global strategist at TCW.


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