Views on the Sovereign crisis

Posted 30.09.2011

On Wednesday 21st  at the Invest Forum in Geneva, Patrick Arthus shared with an audience of wealth managers his views on the current market situation and the sovereign crisis. These are some of the points that were discussed.

Solvency cannot be treated as a Liquidity issue

First and foremost the situation of a number of countries, Greece, Portugal and Spain, possibly Italy, has moved from liquidity – financing issue- to an insolvency situation. This means this is not about bridging a temporary situation by providing some financing. It is about the inability of those countries to pay back their debt. This cannot be treated by lending.

There are three steps that need to happen in quick order:

-        A restructuring: basically a right-off of a very large portion of the debt

-        Loans, as the countries have to finance their most urgent needs to ensure stability

-        Structural reforms: state budget reforms, tax changes, infrastructure development, education policy … in order to tackle the roots of the problem.

What makes the situation especially difficult is that the banks  in Europe are heavily invested in Government bonds, as they have been prompted by the states to do so via the liquidity and solvency constraints imposed on them for example via the Basle agreements. So a restructuring would hurt them greatly, with the danger of the liquidity and then eventually the solvency issues spreading inside the whole European financing system.

The key factor to get back under control is the dependency of the state’s finances to the external world, so that the financing can effectively be done by personal savings. That means getting the trade balance back in the green. The only way to achieve this quickly is via a massive devaluation of the currency. This is not an option in the context of the Euro zone; Hence the discussion around a potential exit from certain countries.

The cost and complexity of any exit would be mind blowing, not to mention the risk of contagion and the consequences on the European banking system as a whole. Greek banks balance sheets are loaded with Greek government bonds and owned by foreign banks, typically French. Any solution including a default from Greece will have to make sure that the banking system is protected: because it will allow the Greek economy to function and even more so because it will avoid a disaster in the rest of Europe.

For Ireland and Spain, the situation seems to be on better tracks. Ireland now shows a positive trade balance which means they have time to get their internal finances in order. As a result their 10 years financing rate has gone down 600 bpts in one month. Spain is on the way to achieve the same goal, having already halved their trade deficit. For Greece there are limited hopes they can achieve it, and in Italy the jury is still out.

Critical to restoring public finances is growth. It is therefore risky to deploy an aggressive budget deficit reduction as it would translate immediately into a decline in GDP growth, endangering tax revenues therefore ultimately failing to achieve the desired goal: deficit reduction.

So currently the battle to avoid contagion to Italy.   The EFSF will not solve an Italian problem. The amounts are just too large and the Bundesbank would oppose it.

Market situation

This situation has created a market where valuations are not driven by fundamentals any more, rather by risk factors and fear. There has been, and this is likely to last for some time a loss of influence from fundamental / value analysis. That an asset looks cheap today does not mean it will not look even cheaper tomorrow and this has nothing to do with its intrinsic merits.

Prices are driven by the news flow and sovereign CDS levels; and by public positions taken by senior politicians across Europe.

As for Gold, the point is its price usually is a function of money supply; worldwide supply has increased over 17% in a year… this plus a number of factors such as central banks reserve policies…

Credit Crunch: biting back?

There is currently limited long term financing available for the banks. It is very difficult to find 2 years and above money; some markets, like the USD for some banks, notably the French banks, are almost closed. This means that there is no long term financing available for Capex, which is not very good news for the economic growth. It also forces those banks from some market segments, threatening their profitability. And this situation will remain until bank spreads come down, which will not happen in Europe as long as the sovereign spreads don’t.  Because of Basle II and also probably government incentives, banks balance sheets are full of Sovereign paper. This makes them especially vulnerable in those circumstances.

Fundamentally, the role of banks is not to finance states. Their role is to finance the economy. States should be financed by much longer term investors like insurance companies and pensions funds.

On the other side of the Atlantic, the situation is for the least unstable. The last “twist” is unlikely to bring any impact. The issue in the US is to stabilize the real estate market which is so important to the individuals as well as to the overall economy. Twist will bring liquidity to banks… which have already USD 1,700 bn in deposit with the FED. Sounds like the repeat of something seen in 2008…

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