European Crisis - Dynamics of the Eurozone Economy, Threat to Banks from Sovereign Debt Holdings - Case Study Example

The European Sovereign Debt crisis during Table of Contents Table of Contents Introduction 2 Political Dynamics of the Eurozone Economy 3 Financial Threat to Banks from Sovereign Debt Holdings 4 The PIGS – Portugal, Italy, Greece, and Spain 6 The Greek Sovereign Debt Crisis and Effect on the Stock Markets 7 Correlation of Global Financial Markets & Hedging Risk 9 Conclusion 10 Sources Cited 11 Introduction The European Sovereign Debt Crisis has been a main factor in stock market performance in the years 2010 – 2011, primarily because of the large potential exposure that global banks may have to capital losses if the sovereign debt that they hold in government bonds loses value. Banks typically seek to earn income on funds that they are required to keep as capital reserves on loans through low risk investments such as U.S. Treasury Bonds and other sovereign debt instruments. In Europe, it is expected that the major banks may have excessive exposure to Greek, Spanish, Italian, Portuguese, and other bonds from countries who face an increasing risk of defaulting on their debt. Historically, when a sovereign nation’s governmental debt exceeds the annual GDP of the country, the risk increases proportionately that the country will default on all or a portion of the debt requirements, particularly in the circumstances where the debt instruments are held by foreigners or in another currency than the national coin. The ability of sovereign nations to generally print money without formal external control is well established and the example of Zimbabwe is an extreme example of this, but the United States has also reached a debt level that is over $15.5 trillion USD or near 100% of the annual GDP outlook, while the economy is also declining and recessionary,. The U.S. Federal Reserve may also print money to bailout banks in the U.S. and abroad, as it has done following the Lehman bankruptcy, but the Eurozone situation is more complex. Nations like Greece now have their debt valued in Euros rather than Drachma and the sovereign is no longer able to print money, deflate the currency, and cover government debts in the manner of the U.S. central bank. Instead, it appears as if Greece will either default or be bailed out by other Eurozone members, while Wall Street and stock markets around the world react daily to these events and news stories as they herald serious consequences for the international economy that is interconnected during the era of globalization. Political Dynamics of the Eurozone Economy The Eurozone is a political experiment that involves a common currency (the Euro) and a number of sovereign nations that retain their political autonomy in budgetary and domestic affairs while moving together towards ever greater unity in government on the supra-national level. This dichotomy has led to the nations of the Eurozone abandoning their national currencies, but still operating domestically with differing levels of economic production, taxation, social expenditures, and national debt levels. The U.K. and Switzerland remain outside of the Eurozone and under their own traditional currencies, the Pound and Swiss Franc. Germany, France, and other Northern European nations are generally seen as being economically stronger than the Southern European countries, with the acronym “PIGS” being used for the countries Portugal, Italy, Greece, and Spain with the worst economic outlook, budgetary problems, and largest national debt requirements in comparison to GDP. Ireland has been considered a part of this group by some (PIIGS), as the country experienced generally the same problems in an overheated banking, real estate, and finance sector which formed a bubble and popped, leaving the taxpayers and national government responsible for the bailout. Yet, while Ireland and Iceland have already crashed previously before the 2008-2009 meltdown in their national economies due to the problems in financial regulation and overextension of risk taking via leverage in investment banking, the collapse of Greece has been an ongoing event over 2010-2011 with Eurozone leaders Merkel and Sarkozy taking a key role in pledging their own national resources and tax money to “save the Euro” from collapse, as this is perceived as having far worse consequences globally. Financial Threat to Banks from Sovereign Debt Holdings The chart above, from 2010, was published estimating the extent of banking exposure to PIGS sovereign debt by nation and region. The Eurozone was seen as having a potential of “only” $206 billion USD, and the U.S. a $45.6 billion USD exposure, across all of the banking sector. (Parkinson, 2010) Pierre Lapointe of Brockhouse Cooper in Montreal stated that, “For banks, the PIGS debt problem is nowhere as important as the subprime debacle was… The estimated writedowns in PIGS loans … is more than 20 times smaller than during the 2007-2008 credit crunch.” (Parkinson, 2010) However, by 2011 estimates for the total global economic effects, or contagion, in the international economy had increased greatly, i.e, by 8 to 10 times the initial estimate. “…The Bank for International Settlements estimated total exposure of the 16 Eurozone economies to the PIGS economies (excluding Ireland) at USD 1.6 trillion, with France and Germany accounting for 62% of this. French banks’ exposure to the PIGS amounts to USD 493 billion, while German banks’ exposure totals USD 465 billion. Several of the major French banks—including BNP Paribas, Société Générale and Crédit Agricrole—would be particularly heavily hit. If the crisis developed to this extent, then the impact on the US would be somewhat more serious. Total US exposure to the PIGS economies’ debt amounts to USD 200 billion;” (Chao, 2011) By the comparison of these estimates, it is evident that there is either a wide divergence between risk managers internationally in evaluating the “fall-out” for the contagion effects of the Eurozone Sovereign Debt Crisis, or that the consensus changed over the course of only a year to view the situation as much more severe. As these events are entering a period where the United States, U.K., and other countries are seen as already over-extended in debt due to the 2008-9 bailouts which were funded publicly on debt, money printing, and Keynesian economic principles, there is concern in stock markets about the health of the banks who are primarily exposed to PIGS sovereign debt instruments. Because the security of sovereign debt is rated generally at a much higher level than corporate debt, and sovereign defaults are much more rare historically than corporate bankruptcy, these events also have considerable importance for risk managers internationally who control billions of dollars in client investments through pension funds, mutual funds, hedge funds, etc. as well as retail investors. In this regard, risk managers who underestimated the effects of this crisis in global contagion may have failed to anticipate the steep fall in European banking stocks which led the all of the Eurozone markets lower over the period of 2010-2011, some down by over 40% to 50% after rallying over 100% from their 2009 lows. The PIGS – Portugal, Italy, Greece, and Spain The table below illustrates the problem with PIGS sovereign national debt as it relates to percentage of annual GDP, external ownership of debt instruments, and the current national deficit between tax revenues and budgetary spending in 2009. (Cabral, 2010) Table 1. Government debt, external debt, and Internal Investment Position at year-end 2009 Table 2. The PIGS’ combined current account, trade, and income balances These statistics alone should have been sufficient for most risk managers to understand the potential for a crisis in Eurozone sovereign debt, and indeed this issue was widely discussed in the financial press. Yet, even today, there is not a clear resolution of the Greek issue, with a potential 50% “haircut” on Greek debt being proposed by bondholders, and Greek PM George Papandreou proposing a national referendum on any Eurozone bailout accord. With the centralization of large investment funds, retail investors trading on news stories, high-frequency trading, ETFs, and historically low interest rates in many Western countries, the global stock markets have not only been volatile in reacting to the European Sovereign Debt Crisis in 2010-2011, but have also been moving in correlation to a high degree. This means that the Eurozone Crisis can spread easily to affect other weak economies like the U.S., U.K., and Japan, or force a country with a strong currency like Switzerland to peg its exchange rate to the Euro. Foreign Exchange Rate fluctuation also causes major issues in the stock market due to the effects of international currency arbitrage. Thus, when the Euro weakens against the dollar, or vice versa, the global stock markets will also factor this issue into economic determinations of corporate value and business revenue effects when evaluating individual stocks or companies for investment. The quick changes in this sector due to political developments have consequently changed the value of many companies and banks, causing subsequent volatile changes in the prices of stocks and bonds. The Greek Sovereign Debt Crisis and Effect on the Stock Markets Financial analysts suggest that current regulations encourage banks to treat governmental sovereign debt as “risk free” for while there is a recognized wide range of ratings on these bonds, banks can generally keep them in lieu of cash reserves required by the Basel Accords and other industry regulations. As the loss of the U.S. “Triple A” bond rating this year by Standard & Poor’s, the current negotiations for a 50% “haircut” on Greek bonds, and a similar downgrade to Italian sovereign debt instruments all show is that this assumption by regulators that encouraged or permitted them to view sovereign debt as “risk free” may have been mistaken. “For example, analysts at Credit Suisse looked at 49 major banks and posited what would happen if they absorbed markdowns on their Greek, Portuguese, Irish, Italian and Spanish debt in line with the losses those bonds have already suffered in the markets. That included a 50 percent markdown on Greek debt. While only a handful of banks would fail, almost all of them in Greece, more than half the banks would need to raise new capital to bring their reserves back to levels considered healthy, Credit Suisse concluded. The total amount of money they would have to raise would be 82 billion euros ($116 billion).” (Ewing, 2011) Banks can issue bonds, sell assets, or offer new stock to investors to raise capital, but any losses or potential losses due to sovereign debt inherently weaken the value of their stock as does the risk of dilution. Therefore, many of the Spanish, French, and Italian banks took large losses in the stock market in the value of their shares in 2011 as the extent of contagion and the seriousness of the Sovereign Debt Crisis became more fully understood by investors. The global stock markets price equities on a daily basis as a part of the “efficient markets” hypothesis, and thus they may also rise when “bailout” accords are passed because the longer term economic outlook may improve despite the bad news of the banks failing. Similarly, the uncertainty introduced by the Greek referendum on the conutry’s bailout could cause the country to exit the Eurozone, and possibly signal that other PIGS countries will do so as well. This will place considerable stress on long-term investment planning based on the stability of the Eurozone model and further seamless economic integration. The relative cost of the Greek bailout is not large in the context of the Eurozone economy, but when this burden is combined with the debt problems of Spain, Portugal, and Italy, the solution involves wealth transfer from Northern Europe to the South that will also cause an increased economic hardship on Germany and France. If the global economy is already considered weak and unstable with the primary problem the debt levels, public and private, in the developed economies and the BRIC nations are surging economically, this portends a potential shift in the dynamics of international relations, as can be seen in China being courted as a bailout sponsor of Greece. Correlation of Global Financial Markets & Hedging Risk Because of contagion, correlation of global markets, and even commodities, equities, and bonds moving in similar directions, the complex economic environment in which the European Sovereign Debt Crisis unfolds may challenge traditional diversified portfolio theory. Therefore there are different strategies employed in investment management to seek out favored companies such as tech sector growth stocks, dividend paying stocks, utilities and consumer goods conglomerates for stability, or market leaders and game changers for outperformance as a means of developing returns that exceed index tracking methods. Some analysts suggest the Federal Reserve’s policy of near 0% interest rates is designed to encourage a “reflation” of the global stock markets because money managers will be forced to invest in stocks to seek yield on investments and greater returns. Precious metals have at times outperformed when banking and financial sector stocks tumbled in the 2010-2011 period, because investors saw the potential of currency inflation due to central bank policies of “quantitative easing” designed to rescue troubled or TBTF banks. Yet, gold and silver remain volatile investments and platinum has failed to outperform gold, suggesting that the precious metals markets may also be difficult to predict as to future direction. This creates a question of what the preferred investment strategy should be in such a global marketplace with reference to investment planning in stocks, bonds, precious metals, commodities, ETFs, and other financial instruments. A typical investment portfolio based upon diversification may have a 30% to 40% holding of bonds, 50% to 60% invested in stocks, and 5% to 15% invested in precious metals or commodities. But some investors prefer to specialize in oil companies, dividend paying stocks, junior gold miners, or high-beta tech sector and research pharmaceutical companies seeking higher rates of return. Thus, to form an investment strategy in this market environment, the investor must first determine what his or her goals are in the market, i.e. capital preservation for retirement, dividends, fast-growth of capital, beating S&P 500 or Dow indexes, or simply earning more than the savings rate of interest. Once the level of risk and intended goal has been determined, then a specialized plan of investment should be made for that specific and individual purpose. The most important aspect to consider is long-short strategies vs. traditional, long only “buy and hold” strategies. Conclusion Greece’s potential exit from the Eurozone could lead to other of the nations of Italy, Spain, or Portugal also exiting the monetary union and reclaiming their national currencies. Similarly, a successful bailout and recovery of the country could strengthen and deepen the long-term integration plans and political union of Europe. Financial planners need to devise strategies that take accord of many macroeconomic and geopolitical contingencies, however unlikely, and this is seen especially in risk management and insurance policy valuations. Another fall out of the European Sovereign Debt Crisis can be thus found in its potential to impact insurance companies, such as AIG in the U.S. after the Lehman Bankruptcy. The weak state of the global economy after the 2008 events and the interconnectedness of the global markets across equities, bonds, commodities, and derivatives internationally mean that the sovereign debt crises of the Eurozone can have a wide global impact and effect many companies, banks, and business relationships. Financial planners must build investment strategies that can adjust to be both long and short market positions according to the changes in macro-economic and political developments in order to avoid inordinate losses or to seek a higher rate of return. Otherwise, quality companies can be purchased when the markets are oversold and held in traditional “buy and hold” patterns while accumulating portfolio positions. Sources Cited Black, Jeff and Randow, Jana (2011). Greece Debt Crisis Is Main Stability Threat to Euro Region Banks, ECB Says. Bloomburg, Jun 15, 2011. Retrieved from http://www.bloomberg.com/news/2011-06-15/greece-debt-crisis-is-main-stability-threat-to-euro-region-banks-ecb-says.html Cabral, Ricardo (2010). The PIGS’ external debt problem. VOX.EU, 8 May 2010. Retrieved from http://ww.tek.org.tr/dosyalar/VOX-307.doc Chao, Wen-Heng (2011). The Possible Impact of the European Debt Crisis on the APEC Member Economies. APEC, 2011-07-11. Retrieved from http://www.bloomberg.com/news/2011-06-15/greece-debt-crisis-is-main-stability-threat-to-euro-region-banks-ecb-says.html Crouch, Colin (2000). After the Euro: shaping institutions for governance in the wake of European monetary union. Oxford University Press, 2000. 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Retrieved from http://www.econ.ucla.edu/mlwright/research/workingpapers/SDRPP.pdf Read More