Ger­many is the real risk

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

As the Greek cri­sis ap­par­ently reaches its cli­max it is odd that the de­fault re­sponse is to seek refuge in “safe” Ger­man as­sets. If, as ap­pears quite likely, the flawed euro-sys­tem re­ally is head­ing into the next phase of its de­noue­ment, then Ger­man as­sets are the soft un­der­belly of the sys­tem, and they are likely to suf­fer most. Here is why:

Fix­ing the ex­change rate in­side Europe was an “orig­i­nal sin” as coun­tries with dif­fer­ent pro­duc­tiv­ity lev­els can­not co­ex­ist in an in­flex­i­ble ex­change rate sys­tem. More­over, fix­ing in­ter­est rates at the av­er­age level for the eu­ro­zone meant that they were too low for Ger­many, and too high for the rest. As a re­sult, we have had no real mar­ket prices in eu­roland for about 15 years. The ef­fect has been to sub­sidise en­trepreneurs in Ger­many, while those in the likes of Italy, France and Spain have been de­stroyed.

The ob­vi­ous point is that Europe’s cri­sis is at root a bal­ance of pay­ments prob­lem. Since the euro’s in­cep­tion, Ger­many has run a cu­mu­la­tive trade sur­plus ver­sus eu­ro­zone na­tions of about EUR 1 trln. It is ax­iomatic that within the eu­ro­zone the sum of the cur­rent ac­counts and cap­i­tal ac­counts must equal zero. This i mplies that the Ger­man fi­nan­cial sys­tem, since 2000, has ac­cu­mu­lated EUR 1 trln of pa­per is­sued by eu­ro­zone na­tions (less in­vest­ments made by Ger­man firms in other sin­gle cur­rency mem­ber na­tions and debt re­pay­ments made by Ger­man in­sti­tu­tions).

Hence, Ger­man banks, pen­sion funds and in­sur­ance firms are prob­a­bly car­ry­ing as­sets from the non-com­pet­i­tive eu­ro­zone coun­tries of EUR 800 bln-1 trln. If the eu­ro­zone were to fail, this would cost Ger­many Inc per­haps EUR 500 bln; enough to wipe out the cap­i­tal of its bank­ing sys­tem (about EUR 350 bln the last time we looked). Hence, if Greece were to get a 50% hair­cut on its debt, the next ques­tion would be what about Italy, Spain and Por­tu­gal— one un­der­stands why An­gela Merkel is fight­ing to have the Greek loans re­paid.

Dur­ing the “good old days” of flex­i­ble ex­change rates in Europe, when one econ­omy sold “too much” to another econ­omy, com­pa­nies in the sur­plus na­tion tended to ac­cu­mu­late the deficit na­tion’s cur­rency. If Ger­man firms had pock­eted lots of French francs, they could: (i) rein­vest in France, (ii) buy their French com­peti­tors, (iii) hold francs and earn higher in­ter­est rates, or (iv) repa­tri­ate funds into deutschemarks. The ef­fect of these money flows and price ad­just­ments was a self-reg­u­lat­ing sys­tem. In the ex­treme case, the cen­tral bank of a deficit coun­try could de­value its cur­rency, which had the ef­fect of quickly rein­ing in Ger­man sur­pluses.

The mon­e­tary ad­just­ment mech­a­nism in the eu­o­zone is trick­ier as it takes place through the Euro­pean Cen­tral Bank’s clear­ing sys­tem and shows up with those in­fa­mous Tar­get 2 bal­ances. The Bun­des­bank presently has an ap­prox­i­mate EUR 530 bln credit with the ECB, against which an equiv­a­lent sum of money has been printed. The corol­lary is that any sys­temic prob­lem in the pay­ment chain would re­sult in an abrupt and sud­den col­lapse in Ger­many’s money sup­ply. Of course, on the other side of those Tar­get 2 bal­ances are Europe’s weak links, led by Italy and Spain with debit en­tries of about EUR 200 bln each, and Greece with around 100 bln.

We fail to see why the po­ten­tial un­wind­ing of this un­sta­ble sys­tem should cause its prin­ci­ple guar­an­tor to be seen as a safe haven.

There is a real risk that in a lit­tle more than a blink of an eye Ger­many moves from hav­ing a glut of liq­uid­ity to ex­pe­ri­enc­ing a huge col­lapse in liq­uid­ity. If Greece does in­deed do the sen­si­ble thing and leaves the euro, then the next ones to go will likely be the Ital­ians, and at that point all bets are off. Given that this is the path we seem to be wind­ing down, we would ad­vise selling Ger­many.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.