- A Dysfunctional European Union
- A Simple Solution
- Comparing the EU to the US
Clowns to the left of me, Jokers to the right,
Here I am, Stuck in the middle with you.
Stealers Wheel 1973 classic, “Stuck in the Middle With You.”
Many fiscally responsible countries in the European Union (EU), private creditors holding EU sovereign debt, and investors across the world feeling the effects of increased volatility are wondering how they got stuck in the middle of a dysfunctional union of 27 countries. If you thought the US political gridlock was bad, look at how long it takes for each EU bailout package proposal to get passed by each member country. In addition to dysfunctional leadership, public opposition to a bailout package poses an additional roadblock. This is evident in a recent poll that showed 66% of Germans opposed a Greek bailout (1). Although there will always be public opposition and political self interest at hand, desperate times call for drastic measures.
If the EU took a unified effort, a quick look shows that additional turmoil could be avoided by agreeing on a simple solution. This proposal is based on each country taking a percentage of a bailout package based on their percentage of Gross Domestic Product (GDP) relative to the EU’s overall GDP. The countries involved in providing funds for the package will be the ones with a relatively better fiscal situation than the troubled countries, in other words, the best of the worst countries. In addition, private creditors will be required to take a 25% haircut on the debt holdings of countries receiving bailout funds. The top chart below looks at the current fiscal situation of the top 15 Eurozone countries, based on GDP, and the second chart shows what they would look like after the bailout package.
Details of a simple solution bailout package:
1) Countries receiving funds to reduce their debt to GDP to 80%: Italy, Belgium, Greece, Portugal, Ireland
2) Spain’s fiscal situation is a concern so they will not partake in contributing to the bailout package
3) Private creditors’ 25% haircut will come from extending maturities and reducing face value
4) Total package: $1.2 Trillion; Creditor’s: $303 Billion, Germany: $258 Billion, France: $202 Billion, Remaining Countries: $451 Billion
On 9/29/11, Germany exceeded this base case expectation with a pledge for $287 Billion towards a package for troubled EU nations (1). Germany and France account for over 50% of the Eurozone’s economy and they would account for over 50% of the public sector’s contribution to the bailout package. Similar to how the U.S. handled the 2008 crisis by sitting down every major investment bank’s CEO in a room and requiring them to take funds from the Troubled Asset Relief Fund, Germany, France, and the IMF need to sit down all the leaders from the remaining 25 countries and require them to sign on to an agreement. Each country within the EU got into bed with each other when they signed on to be part of the EU. There are many benefits of being in the EU, which have benefited most of the regions’ economies, and there will be pitfalls, like the current crisis. The aggregate debt to GDP within the Eurozone is roughly 81%. Some of you may raise an eyebrow when you compare the EU debt crisis to the U.S.
According to a June 2011, Congressional Budget Office report, “Recently, the federal government has been recording budget deficits that are the largest as a share of the economy since 1945. Consequently, the amount of federal debt held by the public has surged. At the end of 2008, that debt equaled 40 percent of the nation’s annual economic output (a little above the 40-year average of 37 percent). Since then, the figure has shot upward: By the end of this year, the Congressional Budget Office (CBO) projects, federal debt will reach roughly 70 percent of gross domestic product (GDP)—the highest percentage since shortly after World War II (2).” In addition, the report estimates that the percentage of debt to GDP will exceed 100 percent by 2020 (2).
Volatility has increased significantly since the EU crisis took center stage earlier this year. The iPath S&P 500 Volatility Index, an ETF that tracks the volatility of the S&P 500, has increased over 46% from January 1, 2011 to September 30, 2011. The increased volatility has been a direct result from uncertainty caused by poor coordination and untimely decision making among EU leaders. If the crisis can be resolved in a timely manner, this increased volatility will be subdued. As a result, many investors who have been on the sidelines because of the elevated volatility will begin to take on more risk. In addition, the “risk on-risk off” trade that has been prevalent will decrease. Corporate bond yields in the EU have remained low relative to the yields on EU’s sovereign debt. If the inaction by EU leaders continues or if austerity measures cut significantly into corporate revenues, corporate bond yields could increase and cause further damage to the global recovery.
Luke Nagell
Portfolio Manager
Sources:
(1) http://www.usatoday.com/money/world/story/2011-09-29/german-parliament-eurozone-bailout-fund/50598038/1
(2) http://www.cbo.gov/ftpdocs/122xx/doc12212/2011_06_22_summary.pdf
(3) http://epp.eurostat.ec.europa.eu
Disclosure:
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
