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The European Flu of 2011 GLOBAL PROSPECTS

financial and political crisis

is underway in Europe. Just

listen to comments made by

Europes leaders over the

past two weeks. According to UK PM David

Cameron, the European Union is an or-

ganization in peril representing a continent

in trouble. Per Nicholas Sarkozy, the euro

will sooner rather than later be too strong

for some and too weak for others, and the

euro zone will explode. German PM An-

gela Merkel perhaps overdid it when she

said that Europe is in one of its toughest,

perhaps its toughest hour since World War

Two, but one gets the idea. As this article is

being written, Mr. Sarkozy and Mrs. Merkel

have announced their plans to reopen the

fundamental European Union treaties.

There is no question that Europe is sick.

Since European markets began their

convulsion in mid-July, the German DAX

has posted a -18% return, the French CAC

40 a -17% return, the Spanish IBEX -18%

and the Italian MIB -22%. As recently as

November 25th, the declines were in the -

20-30% band across the board. The

Bloomberg European Financial Index has

returned -35%. Major European banks in-

cluding Barclays, Deutsche Bank, Banco

Santander and Credit Suisse have seen their

share prices decline by as much as 50% (or

more in the cases of BNP Paribas, Societe

Generale, and other major French lenders).

The sovereign debts of nations such as Italy

and Spain have been successively down-

graded by ratings agencies and more im-

portantly repriced by markets. When Ital-

ian yields shot up from 3.3% to 7.3% be-

tween early July and late November, it

translated into mark-to-market declines of

30% or more for holders of Italian 10-year

bonds. In this environment, it is almost

astounding that the euro has onlydeclined

by 10% at its worst.

To read the press, you would think that

the causes of the turmoil are related exclu-

sively to government policy. The conserva-

tive view, perhaps most forcefully expressed

in the German magazine Der Spiegels series

on the Euro-crisis, titled Die Geldbombe,

is that the profligacy of the European wel-

fare state is responsible for the crisis, and

that the debt-to-GDP ratios of the weaker

European states are ultimately caused by

the spending policies of European govern-

ments. The more liberally-minded view,

reliably and articulately presented in Finan-

cial Times economics editor Martin Wolfs

twice-weekly column, is that a failure of

growth-oriented government policy has

prevented the GDP part of the debt-to-

GDP ratio from growing as rapidly or force-

fully as it needs to in order to make Europes

national debts palatable or even sustain-

able.

While both views are simply true, nei-

ther fully explain the crisis as it has unfolded.

The main issue is that on top of having to

sustain costly welfare states, European na-

tions need to bail out a financial system still

laden with bad debts. Europe is in the midst

of a banking crisis surrounding the chal-

lenges and costs of dealing with decades of

bad debts, both private and public, accrued

by Europes banking system. This European

crisis is ultimately an extension of the glo-

bal debt crisis which gripped the United

States in 2007-08 and which was never

addressed fully or openly on the continent.

As in the United States, the resolution of the

crisis will require a mix of fiscal interven-

tion on the part of governments and mon-

etary intervention on the part of Europes

central bank, the ECB. However Europe is

in a more vulnerable position than the

United States circa 2008. The oversized debts

of Europes sovereigns and the slow growth

of Europes economies limit the flexibility

of Europes fiscal policy. Moreover, the

ECBs tight mandate to enforce price sta-

bility and not to serve as a lender of last

resort limits the extent to which mon-

etary policy can be applied. The end result

is a highly volatile situation and profound

fears that Europes financial flu of 2011 will

transform into a contagion in 2012.

Two strains of the virus

Just as a doctor treating a patient sur-

veys case history before prescribing a treat-

ment, its imperative to understand the dif-

ferent species of European financial crisis

prior to moving forward with a diagnosis

of todays problems. Greece and Ireland,

the early casualties of the European finan-

cial crisis, provide case studies of the vari-

eties of European financial crisis.

The Greek financial crisis is definitely the

easier of the two to understand: Greeces

government revenues are not sufficient to

fund Greeces expenses, nor is it plausible

that they can be brought to match the ex-

tent of Greeces needs in the near future.

Between 2008 and 2010, Greeces govern-

ment ran a cumulative deficit in excess of

83b EUR. Thats equal to 35% of Greeces

nominal GDP and roughly double the av-

erage tax revenue of Greece, which has run

at approximately 40b EUR per year for the

past three years. Greeces Governments

overspending over the past three years has

been equal to half of its income in any given

year. Unsurprisingly, global bond buyers

have lost interest in capitalizing Greeces

budgetary needs.

Ireland presents a tougher puzzle. Ire-

land was one of the most stable and best-

managed economies prior to the crisis

and among its worst casualties. To give an

idea of the extent of Irelands change, in

2007 Ireland ran a budget surplus. Its debt-

to-GDP ratio, which shrank throughout the

decade, was 25%. Q4 2007 YoY real GDP

growth was 6.2%. Today Irelands debt-to-

GDP level sits at 95%. What happened?

Unlike Greece, Irelands financial crisis was

not driven by basic structural deficits but

rather by the one-off costs of bailing out

the Irish banking system combined with

the drop-off in corporate tax revenue. Na-

tional tax receipts were 59.6b EUR in 2007

and 34.4b EUR in 2010. Meanwhile, the to-

tal costs of the Irish bank bailout, which

are currently held off balance sheet, exceed

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70b EUR, i.e. are greater than double

Irelands annual tax revenue.

How did Ireland get here? The anatomy

of the bailout of Bank of Ireland (BKIR),

one of Irelands largest lenders and prob-

ably its strongest, is instructive. BKIR hasChallenged Loans (impaired, past due but

not impaired, and lower quality loans) of

24.5b EUR against an impairment provi-

sion of 5b EUR. The market cap of BKIR is

2.7b GBP, implying that markets believe

that between recoveries on distressed as-

sets and loan-loss provisions, there is sub-

stantial equity left over on BKIRs balance

sheet. Still, BKIR is a risky proposition, and

as it funds 46% of its asset book via whole-

sale loans, i.e. via short term public bor-rowing, public markets will only remain

open to BKIR if its assets are guaranteed.

Thats where the government has had to

step in. New equity has been infused by the

government into BKIR through a variety

of programs, and moreover, the govern-

ment of Ireland has had to announce its

willingness to backstop further losses that

would accrue to the bondholders. In eq-

uity terms, the government has had to pay

in more than 4b EUR since the crisis startedwhile remaining on the hook for poten-

tially larger equity infusions should the at-

trition of BKIRs loan book continue. Debt

guarantees have sucked up additional capi-

tal. Repeat this process for the three other

lower quality members of Irelands big

four banks and the expense rises to 45b

euros one quarter of Irelands GDP.

Were all Irish now

The challenge in Europe is not dissimi-lar from the one confronted by Ireland:

bailing out banks in a context of weak tax

returns and slow growth. The fiscal defi-

cits themselves are not the challenge. With

the exceptions of Greece and Portugal, the

accumulated debts of European nations are

not all that different today than they were

at the start of the decade. For instance,

Italys debt-to-GDP ratio was 106% in 2003

vs. 120% at the end of 2010. Frances 2003

vs. 2010 numbers are 69% vs 82%.

Germanys are 64% vs. 83%. The Nether-

lands are 54% vs. 62%. Spains are 62%

vs 62%, i.e. unchanged.

The issue is not the debts themselves but

rather what those debts would look like if

massive bank recapitalization and loan

guarantees were piled on top of them. Italys

two largest lenders, Unicredit and Intesa

Sanpaolo, have cumulative balance sheets

of 1.6t EUR. Spains two largest lenders,

BBVA and Banco Santander, have cumula-

tive balance sheets of 1.75t EUR. Deutsche

Bank and Commerzbank have cumulative

balance sheets of 2.6t EUR. BNP and Soci-

ete Generale have cumulative balance sheets

of 3.1t EUR. Imagine if the tier 1 capital of

those banks had to be replaced. Could Spain

add a 175b EUR bailout of its largest lend-

ers to its budget? Could France add a 300b

EUR bailout of two banks to its already

ballooned deficit? For that matter, can Ger-

many afford to bail out its banks?

If Europe sounds like the America in

2008 to you bad loans culminating in big

bank write-offs and a bailout well, youre

right. The difference is that while the U.S

recapitalized its banking system in part by

raising funds at the national level (remem-

ber the 700b USD TARP?), we now know

that the U.S. mostly paid for the bailout via

the Fed, i.e. with printed money. During

2008 and 2009, the Fed increased the size of

its balance sheet by 1.7t and opened as

much as 4.5t in additional liquidity via its

Term Auction Facility. While TARP repre-

sented roughly 5% of U.S. GDP in 2009, the

Feds expenditures represented 35%.

There is no way that the U.S. could have

sustained that level of spending by borrow-

ing in public markets, and neither can Eu-

rope. Borrowing enough money to recapi-

talize European banks and fund the bor-

rowing needs of countries frozen out of

credit markets would increase the debt bur-

dens of all of the European countries to

untenable levels Germany included. Alas,

Germany, fuelled by what we call Weimar

memories, refuses to allow the ECB to

monetize costs of recapitalizing Europes

banking system. Its our considered view

that until Germany prints, Europe will re-

main highly unstable and European finan-cial crises will episodically disrupt financial

markets and indeed the global economy.

No exit

Among the inevitable conclusions of this

analysis is that forcing weak members to

leave the euro will not alleviate any prob-

lems as the issues are as much core as pe-

ripheral. German and French banks are in

fact much more of a problem then tax re-

cidivism in Greece.Another conclusion, and one that is more

investable, is that the monetization of

Europes debts is inevitable. There are two

very straight-forward investment themes

here: a) However the Euro crisis evolves, it

will be highly negative for European finan-

cial companies, the recapitalization of which

will be by necessity highly dilutive. At the

same time, if such recapitalizations are to

occur, they will present opportunities, as

proven by the experience of American banksin the first half of 2009. b) Printing of tril-

lions of euros will be highly negative for the

euro against essentially any other currency.

The euro is trading above fair value as mea-

sured both by interest rate parity models

and Purchasing Power Parity. It is unimag-

inable that this situation can outlast mean-

ingful quantitative easing by the ECB.

But perhaps the most important con-

clusion is that many of the foundational

tenets of contemporary European societyneed to be reconsidered if both monetary

and fiscal union are to be maintained. This

crisis is too severe not to result in funda-

mental changes to the social contract in

Europe, and we watch with a mix of inter-

est and trepidation as to how society will

adapt and react to the medicine required to

ward off Europes financial flu.

The European Flu of 2011 GLOBAL PROSPECTS

HB & DZ