Europe’s hire wire act – safe for now?

June 6, 2011

FOREX, Global Macro

Europe’s high wire act continues but markets reacted positively to news that Greek Bailout II, or is it III or IV, is coming on Friday night. Realistically though all European politicians have done is kick the can down the road to be dealt with at another time with no hint of enduring resolution. Not for Greece, not for Ireland or the rest of the periphery – not yet anyway.

So if you ever needed proof that the EU and the Euro exists on an intellectual level and is a cerebral pursuit then this and the last couple of week’s have proved it all. As Greece totters toward default, even if markets are excited because it looks like they are getting another €100 billion into their account, Croatia and Serbia are readying themselves to try to get into the EU. Is it too long a bow also to suggest that German officials blame of spanish cucumbers for the E.Coli outbreak when the culprit appears to be bean sprouts in Lower Saxony speaks of the very lack of cohesion Europe needs to get through this malaise.

Why Croatia and Serbia would want to join the EU at a time of European turmoil is impossible for those of us half a world in distance and light years psychologically to understand.

The problem with the EU and the Euro is that it is half-baked insofar as the political will for integration didn’t go as far as the union of states that are the United States of America or Australia because each nation wanted to keep its sovereignty intact. That is certainly understandable and was all well and good until a crisis of the magnitude that Europe is now faced with and the choices that confront many national assemblies.

Essentially for Greece and possibly other nations they will need to compromise of sovereignty in order that they retain it. It is a strange conundrum and we confess to struggling to understand how this translates into a EUR at 1.46 versus the USD but that probably says more about how weak the USD is.

Writing in the FT the worlds best Financial Journalist, Martin Wolf, wrote

The eurozone, as designed, has failed. It was based on a set of principles that have proved unworkable at the first contact with a financial and fiscal crisis. It has only two options: to go forwards towards a closer union or backwards towards at least partial dissolution. This is what is at stake.

With the economic crisis of the last few years having fed a growing nationalism which we are seeing at the ballot box in many European countries it seems that the latter option is more likely than closer union. We recommend everyone read the article but here is thee conclusion (our emphasis),

Debt restructuring looks inevitable. Yet it is also easy to see why it would be a nightmare, particularly if, as Mr Bini Smaghi insists, the ECB would refuse to lend against the debt of defaulting states. In the absence of ECB support, banks would collapse. Governments would surely have to freeze bank accounts and redenominate debt in a new currency. A run from the public and private debts of every other fragile country would ensue. That would drive these countries towards a similar catastrophe. The eurozone would then unravel. The alternative would be a politically explosive operation to recycle fleeing outflows via public sector inflows.

Events have, in short, thoroughly falsified the premises of the original design. If that is the design the dominant members still want, they must remove some of the existing members. Managing that process is, however, nigh on impossible. If, however, they want the eurozone to work as it is, at least three changes are inescapable. First, banking systems cannot be allowed to remain national. Banks must be backed by a common treasury or by the treasury of unimpeachably solvent member states. Second, cross-border crisis finance must be shifted from the ESCB to a sufficiently large public fund. Third, if the perils of sovereign defaults are to be avoided, as the ECB insists, finance of weak countries must be taken out of the market for years, perhaps even a decade. Such finance must be offered on manageable conditions in terms of the cost but stiff requirements in terms of the reforms. Whether the resulting system should be called a “transfer union” is uncertain: that depends on whether borrowers pay everything back (which I doubt). But it would surely be a “support union”.

The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support. The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged. How will the politics of these choices now play out? I truly have no idea. I wonder whether anybody does.

Nope, us neither but note the very first bolding, retructuring still seems inevitable.

But while it is sorted out we think this implies for investors and markets an intolerable level of uncertainty and volatility., Our view would be that whatever the current sanguinity and hopeful expectations that in the long run  the EUR/USD rate has to head back toward 1 from 1.50ish presently. It means that even well performing European companies and markets will under perform in local currency (AUD, amongst other) terms unless or until the EUR busts and they can get back their Deutschmarks, Gilders and Francs back.

Lets hope that European policy makers can find a way to get to the other side in what is a spectacular high wire act.

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