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Tuesday, 24 October 2017

Spotlight falls on eurozone

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  • Maturing sovereign bond volumes

In the aftermath of Greece’s financial troubles, the spotlight has now turned to the eurozone. Portugal and Spain face similar situations, and observers are questioning the viability of an economic bloc that comprises unequal partners. The answers to those questions are likely to have profound consequences for the future of Europe, reports Han-Nee Tay.

When Eurostat first drew attention to irregularities with Greek data in its reporting of its budget deficit on January 8, few imagined that could spiral into a eurozone-wide crisis. Four months on, a bailout package has been agreed between the European Union and the International Monetary Fund for Greece. But with other southern European countries also struggling under the weight of massive budget deficits, questions are being raised about the future of the eurozone.

After months of dithering, the EU and the IMF finally cobbled together a bailout package on April 11, their second attempt at drawing up a rescue plan. The two bodies jointly announced they had €45bn (US$61bn) on the table at an interest rate of around 5% for Greece to meet its debt obligations for the year. Of that, €30bn will come from the EU. In March, both bodies had announced a €22bn package too small and lacking in detail to assuage market fears, given that Greece already has to refinance €11bn of maturing debt by the end of May.

While Greece had initially seemed resistant to the idea of drawing down the rescue loans, that now seems increasingly inevitable. Borrowing costs in the capital markets remain painfully high for Greece, at over 7%. But initial investor relief at the announcement of the rescue plan was soon overridden by concerns about the workability of the package and the long term economic health of Greece.

Test case for a continent

“The crisis in Greece is very central for the whole euro currency project,” said Michael Krautzberger, head of euro fixed income at Blackrock Investment Management. “If the members support Greece and the situation is stabilised, the eurozone might regain one of their most important advantages – lower funding costs for all members….Currently, many members have higher credit spreads than many traditional emerging markets, for example South Africa. The market demands higher risk premiums because of the lack of currency flexibility, coupled with doubts on solidarity and support. If the Greece situation gets out of hand, the market will be very hesitant to finance any other member which is perceived as sub-eurozone average and the project would become self-defeating.”

Yields for 10-year Greek bonds had jumped to a year-high of 9.67% in late April, up from 5.634% on January 7, the day before the Eurostat announcement. The euro has also taken a pounding over the last few months, falling to $1.3201 in late April, down from $1.432 on January 7. Such falls in the market are signs of what is to come should Greece’s problems not be dealt with imminently. The market has also punished Portugal and Spain, leading many to question if the eurozone could be better off without its poorer cousins. Germany has been vocal in its resistance to offer help, which is perhaps a sign that even within the eurozone, doubts about the viability of the economic bloc exist and are increasingly given voice.

“[Germany] agreed to the bailout because it ultimately became very hard for them to avoid it,” said Gabriel Stein, chief international economist and director at Lombard Street Research. “They have been kicking and screaming all the way. They were the ones who talked about market interest rates and so on which would be a sure-fire way to kick Greece further when they’re down.”

Experts believe the economic and financial inequality of the 16 countries comprising the eurozone makes a compelling case for its break-up. The single currency and the lack of flexibility in monetary policy-making inhibit countries’ freedom of action when troubles strike. In the case of the so-called PIGS (Portugal, Ireland, Greece and Spain), the fixed exchange rate means that they cannot do anything about their levels of competitiveness in the global market. Greece, in particular, has suffered spectacularly from the global recession after a years-long credit-fuelled boom. As the world struggles to emerge from recession, Greece, with its service- and tourism-driven economy, is finding it hard to get back on its feet.

“There is an issue of competitiveness,” said Paul Rawkins, a senior director in the sovereign ratings group at Fitch Ratings which downgraded Greece by two notches to BBB- early in April. “When you think of competitiveness, you think of churning out goods at an attractive price. That isn’t really what Greece does, it’s very much a service economy; tourism is important and also shipping. So if world trade increases, that will be of benefit to Greece.”

Greece’s small and uncompetitive export base means it has few sources from which to grow earnings to pay for its enormous debt. The country’s budget deficit is nearly 13% of GDP. Its government wants to cut that by four percentage points through austerity measures, meaning tax rises and spending cuts. Even if it is successful, Greece still has to find new ways to revive its economy after the storm has passed.

“For countries that have large imbalances and large leveraging out of their economies and the private sector, like Spain for example, the key question to ask is where future growth is going to come from?” said Moritz Kraemer, head of sovereign ratings in EMEA for Standard and Poor’s. “Credit-fuelled growth is a thing of the past. Over the next few years, the public and private sector will have to deleverage. That will be a huge drag on the economy. The only outlet is net exports and these countries have a pretty weak export base.”

Wider malaise

The fact such problems have materialised several times within the eurozone has sparked an intensified instances of euroscepticism. “There are tremendous problems in the eurozone,” said Geoffrey Wood, professor of economics at Cass Business School. “The southern countries like Greece, Spain, Portugal and Italy all have lost a vast amount of competitiveness and all have vast budget deficit problems. They can’t change the exchange rate, so they have to get their competitiveness back some other way or be stuck in permanent recession. How are they going to do that? The traditional way to do that is to tighten monetary policy but they can’t control monetary policy either.”

At the moment, it seems unthinkable that Greece would self-flagellate by pulling out of the eurozone. Such an action would likely cause a run on its banking system and cause a default. “By disowning the euro and coming up with its own currency, Greece would immediately be opened up to exchange rate risks and it’s quite likely that the debt burden, which is largely held in euros, would rise exponentially,” said Rawkins at Fitch. “They would then likely be heading for a default. There is no provision within the euro area for a country to leave the currency union and Fitch is not factoring this event into its rating on Greece.”  

But others suggest that there are already signs that Greek corporates and households could be preparing for that eventuality. Analysts said that Greek banks have already been experiencing large withdrawals so far this year.

“It seems that the reason they are losing deposits is because cash-rich companies are using their cash to pay off import bills,” said Lombard’s Stein. “Households are paying down debt or withdrawing money and keeping large denomination notes in cash. The first two, the first in particular, is a classic pre-devaluation gambit. If you think your currency is going to devalue, it’s a good idea to pay off your debt.”

In essence, Greece leaving the eurozone would sound the death knell for the rest of the weaker euro countries. Until such time that these countries have also been weeded out, the currency will remain weak. In the longer run, the wealthier countries such as Germany, France and Benelux could benefit from a stronger currency unencumbered by failings of the weaker members. In turn, economic and political integration could become stronger as a membership to a club of equals finally emerges.

To eurosceptics, this is the destiny of the eurozone. “Will Greece be a member of the eurozone in six months’ time?” said Stein. “Probably. Will they be a member in two years’ time? Perhaps. Will they be a member in 10 years’ time? At the moment, that looks highly unlikely.”

For now, the world continues to wait and see what will happen to Greece. Analysts said that some EU countries still need to pass legislation on participating in the bailout package, which is an unhelpful overhang in the market. In addition, the closure of European airports during the week that EU and IMF officials are to meet to discuss the deal adds further delay to an already dire situation. One thing that market participants do agree on is that until details are ironed out, Greece will continue to be a bad word in the markets.

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