a second Greek bailout payment agreed: implications

an agreement

Greece and the IMF/EU have finally agreed on conditions for the latest tranche of bailout money, €170 billion, to be paid to the troubled Mediterranean country.  Greece will now have the funds to redeem €130 billion of its bonds that mature in the next few weeks.

little stock market reaction

Stock market reaction in Europe has been muted–a 2% gain yesterday, a give-back of about half that amount today as I’m writing this.

what went on in the talks?

I find it hard to interpret with any confidence what has been going on in negotiations between Greece and the EU/IMF.  It’s possible that the brinksmanship displayed in the talks on the question of whether Greece would remain in the Eurozone was all a show, performed for home country voters by politicians eager to minimize the negative consequences of any accord for their future electability.  But that’s not what I think.  My take is that Greece–which hadn’t come close to fulfilling the conditions of its initial bailout payment–figured until recently that the EU was negotiating from a position of extreme weakness.  Until the EU made it clear it was willing to let Greece leave the Eurozone, Greece felt it could extract almost any concession, provided it didn’t do so all at once but rather moved the bar a little bit at a time.  Once the EU began to plan for a Greek exit, Athens was forced to become serious about striking a deal.


It seems to me that at the very least both sides have bought themselves some time.  I’d expect that the core EZ countries will continue to strengthen the capital structure of their domestic banks.  It’s understandable that potential buyers of the public assets Greece supposedly has on sale would be reluctant to bid until they were sure that they weren’t purchasing just before a significant currency devaluation.  So we’ll now have a chance to see how serious Greece is about these divestitures–and how desirable they actually are.

We’ll also have a chance to see whether the EU will retain its hard line that starving yourself through austerity is the best prescription for a return to robust health, or whether the ECB monetary policy will be a bit looser than it has let on to date. My guess is that it will.

Implications for stock market investors?  I think they’re less about a change in strategy than about confidence that the strategy is correct.  I view the EU as a low-growth area for an extended period of time.  And, although fears of a “Lehman moment” are off the table (not that markets ever really factored this possibility into stock prices), Europe will be subject to periodic worries about weaker EZ countries like Greece.

So the appropriate stance remains, I think, to be underweight the area and to concentrate on companies which are listed in the EU but which have the bulk of their operations located in the Americas or in the Pacific.

what’s that about Japan?

Actually, a much newer and more interesting macroeconomic development has been going on half a world away.  It’s quantitative easing in Japan.  More on this tomorrow.


Europe’s deal on Greek debt

the Greek sovereign debt deal

Europe appears to have reached another milestone in its circuitous journey toward resolution of its twin debt crises–Greece and its banks’ unknown, but presumably very large, exposure to sub-prime mortgage debt.

Yesterday’s development is that commercial banks in the EU have agreed to “voluntarily” agree to forgive half the amount the Greek government owes them and write down the value of their Greek sovereign debt by 50%.

Although sharply higher stock prices in Asia, Europe and in pre-market trading in the US signal investor relief, I don’t think it’s particularly surprising that the banks would accede to the wishes of their governments to do so.  For one thing, defying your central bankers is never a good idea.  But in this case agreement brings tangible advantages to the banks as well.

Press reports have made it clear that, earning once again their reputation as the world’s ultimate “dumb money,” the big EU commercial banks had enabled hedge funds to bet heavily on a Greek default by taking the other side of hundreds of billions of euros of credit default swaps.  So the banks would be facing mammoth losses if Greece defaulted and they had to pay off.

But the EU has found what it considers a loophole in the language of the CDS contracts. Technically speaking, it argues, if creditors “voluntarily” forgive a portion of Greece’s debt–which they have just agreed to do–that action doesn’t count as a default; the CDS payoffs aren’t triggered.

Maybe this interpretation is sound, maybe not.  But it’s what the EU is going to do.  National regulators will certainly order their banks not to pay any CDS claims.  Hedge funds can sue.  Litigation would doubtless be long and expensive, however.  And it would provoke the ire of EU politicians, who might find ways to make litigants’ lives more difficult in other areas.

So the bank agreement appears to make the threat to bank solvency of their CDS exposure go away.

what I make of the EU situation

To my mind, resolution to the EU financial crisis has three possible outcomes:

1.  The Greece et al sovereign debt crisis spins out of control–causing the failure of one or more major banks, a run on the euro and a collapse of the EU political structure.  While this is going on, we discover that one of the now-defunct institutions has a crucial, but hitherto unappreciated, role in world commerce.  So the global economy comes to a screeching halt, just like it did after the Lehman bankruptcy.

There’s no evidence there’s an EU Lehman and it’s hard to believe the world would shoot itself in the foot a second time.  On the other hand, the EU has shown itself particularly ill-suited to deal with a financial crisis.  recent trading show clearly that global equity investors have been worried about this possibility, but I regard Lehman II as about as unlikely as you can get.  It’s even less likely today.

2.  Same as #1, except no Lehman.  That is to say, a big banking failure paralyzes the EU.  Most of the economic damage is domestic.  There are ripple effects elsewhere, but they’re not gigantic.

It seems to me that today’s news is also the start of taking this worry off the table.

how important is the EU?

Sizing the problem in the most simple-minded way (all I’m capable of), the world economy is divided about 50-50 into emerging and developed markets.  Half the developed part is the US and another 5% is the UK.  That leaves 20% for Euroland.

Suppose banking failure(s) caused a severe recession in the euro area.  Real output drops by 5%.  That would reduce total world output by 1% (5% x .2), and developed world output by 2%, in the year following the blowup.  factoring in ripple effects, the developed world would stagnate; the developing world would power along, but a bit more slowly.  The whole world would grow at, say, 2.5% next year instead of 3.5%-4.0%, if the blowup happened now.

…something you’d like to avoid, but not such a big deal.

As surprising as this thought may be to Americans with cultural roots in Europe, Euroland is no longer big enough to matter that much to overall world growth, except in extreme circumstances.

True, Europe has a lot of accumulated wealth–which we’ve seen on display, I think, in the periodic panic selling that has marked the past few months.  But it’s too wrapped up in what looks to an outsider like petty regional politics to focus on getting GDP to expand.  And much of the rest of the world is passing it by.

3.  The financial crisis is addressed, the banks recapitalize and the EU begins to heal its wounds, following the general trajectory of the US economy with a three-year lag.  Dreary as it sounds, I think this is both the most favorable and most likely case.

equity implications

Not much different from what I’ve been writing for a long time.  In cases #1 and #2, equity investors would be better off not holding EU-listed securities and should shade their other holdings away from companies with a large percentage of their business in the EU.

In case 3, it’s safe to dip a toe in the water.  But growth outside the EU will likely be much better than growth inside.  So the relative winners will be EU-listed firms with large exposure to foreign markets.  In a non-recessionary EU, these stocks stand to be winners on the world equity stage as well, since EU investors will likely concentrate heavily on them.

is a Chinese bailout of Italy in the cards?

the situation

The S&P 500 spiked upward into positive territory toward the close of New York trading yesterday.


The Italian government announced that:

–it had sent a delegation to Beijing last month to speak with state-controlled investment companies there about making major investments in Italy, and that

–a delegation of Chinese investors arrived in Rome for follow-up discussions last week.

Italy’s in trouble


The European Central Bank has been supporting Italian bond prices by buying in the market, but indicates that this help is only temporary.   The consensus view is that, in contrast with Greece, Italy is too big for an EU bailout to handle anyway.

According to the Financial Times, which reported the news online yesterday, China already owns about €75 billion of Italy’s €1.9 trillion in outstanding government bonds.

not a great place to invest, but…

On the surface, Italy wouldn’t seem like anyone’s first choice as a place to invest.  The Rome government is inefficient and dominated by the business and political interests of the Prime Minister, Silvio Berlusconi.  Financial practices in Italy are opaque; industry is dominated by a small coterie of insiders who shape the rules for their own benefit.  The establishment is also very hostile toward foreigners (of course, in China’s case that makes Italy no different from the US or anywhere else in the EU).

On the other hand, Italy may have no choice but to deal with China.

what I think China wants

Italy wants China to buy large amounts of its government bonds.  I think China is willing to do that.

However, that’s not what China itself really wantsI think bond purchases only come in return for China’s ability to invest in:

natural resources, a minority stake in the oil company ENI, for example.  Not just a passive interest, either.  China would also want the right to buy specified amounts of output–at market prices–in order to ensure supply of industrial raw materials in times of shortage.  Maybe China would also like to be able to invest side-by-side with ENI in future projects.

a bank or other financial institution.  It’s a fact of life around the world that no one ever gets to buy a healthy bank.  It’s only ones that have horrible loan books that go on sale.  So buying one that it would immediately have to prop up probably wouldn’t bother China too much.  It’s the inside access to the EU that owning an EU financial institution brings that’s important.

stakes in industrial companies–state-controlled or not–where China can offer privileged access to the China market in return for technology transfer.  China is already doing this in Japan.  If business could be done in renminbi, so much the better.

will any deals materialize?

It’s hard to say.  But it strikes me that if Italy is serious, the chances of finding mutually acceptable terms are very high.  China is being frozen out of the US and other parts of the EU; Italy has few other options.  China wants access, and is probably less concerned about money; Italy needs cash.

investment implications

There’s at least some chance of a sharply positive turn away from the psychology of worry that now dominates investor thinking about the EU periphery.  Not something to bet heavily on now, I think, but something to monitor carefully.  (The ultimate buying target for us, in my opinion, is well-managed EU multinationals with substantial non-EU businesses.  Speculate at your peril about what trashy Italian companies China might invest in.)