I found this an interesting take on the Eurozone crisis from one of the UK’s leading hedge fund managers. Crispin Odey starts out, in typically English self-deprecating fashion, by noting that every time he announces he is bullish (as he did in his recent quarterly investor call) the market takes an immediate plunge. On this occasion, as he points out, there is no doubt that Europe’s politicians have made the Greek situation worse by their ham-fisted response to the sovereign debt crisis.
The shorthand story of Greece (according to Odey) is that this was an economy, not unlike many emerging market economies, in which prior to entry into the EU and more importantly the Euro, tax revenues raised 25% of GNP, the government spent 28% of GNP and the deficit of 3% of GNP was funded by the printing press. The ensuring inflation of 10% meant that interest rates were at 15%. Government debt loitered around 40% of GNP making interest payments equal to 6% of GNP. Stability of a sort prevailed, poverty of a sort held rein.
The Greeks enter the Euro. The government starts thinking like Brussels. Spending rises effortlessly towards 40% of GNP. Taxes rise to 31%. The shortfall is no longer monetised. Fellow Europeans now buy the debt issued. Interest rates fall to Euro levels. Average cost of debt falls to 5% and the government contents itself that although their debt has risen to 120% of GNP they are still only paying out 6% of GNP in interest payments. Then the lenders finally awake from their happy slumbers and realise that this debt is never going to be repaid. The wake-up call came from the new government denouncing the previous government’s tax revenue numbers. What should have happened?
Greek government spending should have to fall back to 25% of GNP. Taxation should be held steady at 28% of GNP. The 3% surplus should be available to pay interest on the debt outstanding. The fall in GNP before any multiplier effects would be a 15% decline in GNP. To make it a little easier for the government imposing this austerity package, the lenders should agree to a cut of 50% in the value of the debt outstanding. 3% on 60% is just about okay. It is certainly not great value. However the reason we are in this mess I s because the authorities have dithered over what to do.
Since everyone knows that the debt is only worth 50% of par, banks have not only been cutting their credit lines with the Greek banks but also worrying about who is owning the Greek debt. Hence last week’s silence in the interbank market which echoed that soundlessness of the interbank market soon after Northern Rock and again Lehman’s went down. The problem with my solution is that the ECB has been accepting these Greek bonds as margin collateral as fast as the Greek banks have had their credit lines pulled by the other banks. If they had agreed to the common sense proposal, the Greek banks might have defaulted and the ECB lost over £40 bn. They have no balance sheet.
Last weekend European governments, in a remarkable show of unity, agreed to underwrite the whole of the sovereign debt markets in Europe, and this have solved the inter-bank problems. However they have ensured that the Euro has fallen 7% in a month against the US Dollar. The weaker sovereign credits in Europe have strengthened but the paradox is that the equity markets having rallied hard last Monday faded fast as the week progressed.
The German people are rightly incensed at bailing out Club Med because ultimately it means that they will get inflation. However they should be secretly happy that just when exports are booming, their currency for the first time is making their product even more attractive in price. This bail out of last week also means that the prospect of low interest rates stretching out into the distant future is also assured.
So why are stock markets so weak? My only answer is that they did not like the liquidity threat posed by that inter-bank crisis. It reminded them rightly of two years ago. Equally there is fiscal tightening. Government expenditure should be hacked at in the Club Med countries as well as in the UK. Demand must be weak next year. Few people own equities.
At a conference in Milan last week, less than 10% of attendees had more than 20% of their money in shares. That of course makes equities volatile, but also cheap. Equities are cheap against cash, bonds and property and more importantly the corporates are the only rich sector of the economy. Taxes are rising but the attack is definitely on rich individuals. The corporates are seen as employers, and they are well organised to lobby hard with governments.
Having predicted at the beginning of this year that this was going to be a trading year, I have been knocked back – temporarily I hope - but for all the above reasons I still remain optimistic. The election in the UK is a sideshow. Remember 75% of the legislation in the UK now emanates from Brussels. We are governed by an electoral class which starts playing politics at university and listens little to an outside world.
It is unpopular, interchangeable and dangerous. If only politicians bled? Remember that less than 3% of all Scotsmen pay income tax, that over 80% of Welsh GNP is a transfer payment from the UK and that the top 6% of tax payers pay over 44% of the total income tax collected. We now officially live in a world of redistribution, one in which only companies can easily survive.
The stock market feels weak, but as yet there are no broken bones. The trend remains up.
My comment: Remember that politics is the art of the possible and nobody should underestimate the domestic political concerns that are making a unified response to the problems of the Club Med countries so difficult. It still seems likely that while the EU bailout has bought Greece some time, the odds on an eventual restructuring of the euro, which may involve some countries having to leave the monetary union, remain real.
