The euro rebounded sharply yesterday.
Why the excitement? Well, the European Union has agreed to lend Greece up to €30bn at a rate of 5% over three years – but only if it absolutely has to – while the International Monetary Fund (IMF) will contribute €15bn.
So has Greece been saved?
In a word, no…
Greece must cut its spending
The euro’s rebound is understandable. One immediate threat has been removed from the eurozone.
The EU-IMF rescue deal takes away some of the concerns that Greece could imminently face a bond strike, where everyone refuses point blank to buy Greek debt. The yield on Greek ten-year bonds has fallen back below 7% after rising as high as 7.51% last week.
But that’s hardly a vote of confidence given that Germany can borrow at around 3%. The trouble is that none of this helps Greece with its fundamental problem. The offer of help from the EU and the IMF merely makes it easier to roll over its existing debts. It doesn’t help the country to pay down that debt.
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The only way for Greece to cut its debt – without resorting to default, or leaving the eurozone – is for it to take steps to cut its spending. But that’s going to be horribly painful. “This is a short-run fix, not a long-run solution,” David Owen at Jefferies Fixed Income tells The Telegraph. “At the end of the day, Greece has to carry out monumental fiscal tightening even as it slides deeper into recession. They risk chasing their tail.”
As the IMF’s managing director, Dominique Strauss-Kahn, put it: “The only effective remedy that remains is deflation. That will be painful. That means falling wages and falling prices. There is no other way for Greece to become competitive.”
Of course, there’s only so much pain that a country can take before it decides that a better solution is just to tell its creditors they can sing for the money. The likes of Strauss-Kahn might insist that defaulting or quitting the eurozone are not options for Greece. But tell that to Greek public servants, or the country’s taxpayers (rare as they may be).
What will happen when other eurozone countries run into trouble?
And the question also arises – what happens if and when other eurozone countries run into trouble? Where will the bail-out money come for them? As Collin Ellis at Daiwa Markets tells Bloomberg, “the hotch-potch way they’ve put the package together wouldn’t have been feasible for the likes of Spain.” Meanwhile, former IMF chief economist Simon Johnson has argued that the EU should consider putting together a “pre-emptive” package for Portugal, which is also trying to cut its deficit.
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And as Gary Jenkins at Evolution put it to the Financial Times, “It opens up a can of worms.” If EU members can all rely on bail-outs, then “can a lender presume that they are all joint and severally liable for the debts of each other?”
If that’s the case then “over time one would expect Bund yields to start to rise… why lend to Germany at 3.1% when you can lend to Greece at say, 6%?” That’s precisely what German taxpayers fear of course. And it’s yet another reason why this rescue package could fall at the last hurdle.
Why Britain should be worried
One country that has no chance of an external bail-out of course, is Britain. BNP Paribas suggested yesterday that the brief respite for Greece might see the market turn its focus on the UK. “We think the UK could be the next concern for the market.” In terms of our budget deficit – currently running at 11.8% of GDP, compared to 12.9% for Greece – we’re worse off than Spain, Portugal or Italy.
Even cabinet minister Ed Balls’ little brother thinks we should be worried. Andrew Balls is head of European investments at bond fund giant Pimco. “At a time when markets are focused squarely on sovereign risk, there is a danger that a loss of confidence in the UK’s ability to put its fiscal house in order could lead to pressure on the British pound and in turn pressure on the Bank to tighten monetary policy in spite of weak growth.”
However, I’m not convinced the attention of the ‘bond vigilantes’ will turn to the UK just yet. The looming election leaves too much uncertainty over what could happen. But there’s no doubt that if we don’t see a convincing plan to tackle our own debts from whoever’s in charge come 7 May, then we can expect long-term interest rates to be pushed higher, and sterling to be pushed lower.
The euro’s rebound will be short-lived
But if attention does turn from Greece, I suspect the next victims of the vigilantes will be Spain or Portugal or Italy. Investors will want to know if there’s bail-out money available for them too. I suspect the euro’s rebound will be fairly short-lived.
Of course, the upheaval in Greece and other parts of Europe doesn’t mean investors should avoid the whole region. You just have to pick and choose. We look at some of the more interesting areas to buy in Europe in the next edition of MoneyWeek magazine, out on Friday (if you’re not already a subscriber, subscribe to MoneyWeek magazine).
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