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Currencies - Crisis & Opportunity

The road to hell is paved with good intentions. According to some estimates, Germany will contribute approximately 28% of the €130 billion (approx. US$170 billion) bailout recently agreed for Greece; yet, rather than expressing their gratitude, protestors on the streets in Athens burn German flags. While some are celebrating that Greece is – at least for now - not falling into chaos, we are rather concerned about major shifts in European policy making that have unfolded in recent months. Where there is a crisis, there may be opportunities – but not necessarily in the places one might expect.

  • The exposure of financial institutions towards Greek debt. A lot of progress has been made in making the European banking system more robust; the envisioned 53% write-down of Greek debt is priced into markets already. Concerns regarding outright exposure to Greece have abated. Rather, concerns linger about the inter-dependency across financial institutions, the potential “contagion” as other countries – and thus financial institutions across Europe and beyond - may be considered at increased risk of default.
  • In 2010, Germany exported €5.9 billion worth of goods to Greece, a 10.2% drop versus the previous year. While significant, Germany’s trillion economy could stomach losing exports to Greece.
  • Germany’s desire for peace in Europe.

It’s the last point that must not be underestimated. A crucial driver behind the “European project”, the founding of the European Economic Area, succeeded by the European Union, as well as the Euro itself, is a desire by policy makers to create a politically and socially stable, peaceful Europe. Throughout the process, Germany has been very willing to subsidize many corners of Europe. Indeed, while there is public backlash against the German chancellor Merkel’s handling of the bailouts, the German opposition has indicated it might be even more willing to write checks, going as far as suggesting that Southern Europe needs a modern-day Marshall Plan.

Technocrats will argue that a Greek bailout is necessary. Note, though, that while Fitch Ratings just upgraded Iceland (to BBB- from BB+), it downgraded Greece from CCC to C (“default highly likely in the near term”). Iceland’s situation is different, but shows that undergoing shock treatment might lead to a faster recovery than the drama Greece has chosen to pursue.

Importantly, Germany now “owns” the Greek drama. As “experts” impose frugality on Greece’s budget, it is those experts that will be blamed by Greek politicians for any problem or failure that is encountered. Until recently, the reality was rather different: at the time, it was the bond market that was in charge, dictating the terms of how policy makers in the entire Eurozone acted. We have frequently commented on this ‘dialogue’; if it hadn’t been so serious, it would have been farcical to see policy makers commit to implement reform based on pressures by the bond market; the moment the pressure abated, however, those promises became distant memory, only to get a prompt reminder by the markets that there was to be no fooling around, by way of renewed upward pressures on rates.

For now, policy makers have won the upper hand. Relative calm has come back to the market, but at a price: for Germany, it is that it now owns the Greek problem. And it remains a problem, for it has only been patched up; any reference to Greece’s financial health is still an oxymoron. It is not good enough to have averted a Greek meltdown: if Europe does not want to disintegrate, policy makers must find a way for Greece to own its own problems.

Another price has been paid on the monetary front. Since November 1, 2011, when Mario Draghi became President of the European Central Bank (ECB), we’ve witnessed a seismic shift in how monetary policy is being conducted. While we applaud Draghi for his clarity and determination, his decision to provide almost €500 billion in three-year financing to banks (LTRO) at a mere 1% may come at a tremendous cost. Together with another dose of cheap financing to be provided at the end of February, the ECB may have created a monster. The good intentions are clear: banks require more capital, yet market conditions remain difficult and sovereigns may not have sufficient resources to inject capital. Unlike the Federal Reserve (Fed) that brags about delivering a $70 billion plus “profit” to the Treasury (the dirty secret is that the more money a central bank prints, the more securities it buys, the more interest it earns and thus, the more in “profit” it earns, ignoring the not-so-subtle fact that purchasing power is put at risk in the process), the ECB “splits the coupon”, charging only 1% on loans, boosting the profits of European banks. However, the ECB’s LTROs are a Faustian bargain, as there is no way in heaven or hell – at least in our estimation – that such a vast amount of liquidity – in the order of magnitude of a trillion dollars – can be absorbed in three years, when it is time to pay it back.

For the ECB, the LTRO’s represent a considerable risk to its credibility and flexibility. A key advantage of European central banking over that of the Fed had been flexibility; previous facilities – conceptually not all that different from the Fed’s discount window, where banks can get a loan from the central banks by posting collateral – could be ramped up and down based on demand, allowing European central banks (the Swedish Riksbank was particularly agile during the crisis) to swiftly react to market conditions. In contrast, the Fed’s approach has been to buy trillions in securities, simply guessing at what the right amount of money printed would be to stabilize markets, ending up with a huge balance sheet that is inherently inflexible. Now, courtesy of the ECB’s generosity, the ECB has created a similar monster. Fed Chair Bernanke might argue he can raise rates in 15 minutes (by paying interest on deposits); ECB’s Draghi might claim similar power. In practice, however, we simply cannot see how either central bank can mop up trillions of dollars worth of liquidity at the flick of a switch should the need arise.

For now, however, the market appears ecstatic. Banks are recapitalized due to pixie dust offered by the ECB (more formally known as LTRO). As such, we do not expect any collapse or disintegration of the Eurozone in the short-term. Indeed, banks might ultimately get strong enough to stomach further defaults.

It’s not too late for policy makers in Europe to disentangle themselves from “owning” the Greek problem. If policy makers are so “Gung-ho” about having Greece make its debt payments, why not simply make those payments on behalf of Greece, but then let Greece deal with its budget on its own? I.e. cut the funding, yet service the creditors from the European Financial Stability Facility (EFSF)? It would a) save resources by not stuffing money into a black hole called Greece; b) cushion any blow on the European banking system as bond payments would continue to be made; and c) leave it up to the Greeks, rather than the “experts” to balance the Greek budget, thus mitigating any public discontent targeted at the likes of Germany.

These “experts” are already setting up a separate account that will be funded to ensure debt service payments are made. But beyond that, policy makers are getting ever more entangled in domestic political battles. While we favor European fiscal integration, such integration must come as a result of market pressures, followed by domestic conviction, not by German, Dutch, Finnish or IMF dictate. Instead, the course Europe is on may avoid chaos now, but may lead to disintegration down the road. These are serious matters, as the odds of anarchy, followed by military control of Greece have increased substantially. When we suggest that the road to hell is paved with the best of intentions, we are serious.

What does it mean for the euro? Massive short positions previously built-up need to be unwound. As central bankers around the world hope for the best, but plan for the worst, lots of money is being printed: by the Fed, the ECB, the Bank of England (BoE) and Bank of Japan (BoJ), to name the prime instigators. Commodity currencies, i.e. the Australian Dollar (AUD), New Zealand Dollar (NZD) and Canadian Dollar (CAD) should be the main beneficiaries. While these currencies have performed well, Australia is undergoing some domestic political turmoil and Canada’s fate is closely linked to that of the U.S.; as a result, the NZD would be our favorite in that group. Having said that, geopolitical tensions and monetary easing have boosted oil prices in particular, causing headwinds to global economic growth and, with it, also to commodity currencies. If those headwinds play out further, we would make the Norwegian Krone (NOK) our preferred choice, as Norway benefits from rising oil prices, as well as providing investors with relative safety in Europe. It’s not surprising that gold, the one currency with intrinsic value, continues to appreciate in this environment.

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Founder, Portfolio Manager
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