It is an understatement to say that the markets were very challenged in May. After a reprieve of several months, the European debt crisis re-emerged with a vengeance as the Greeks failed to form a coalition government after the May 6th election, throwing the country’s future in the eurozone into question. Equally troubling is that the crisis has spread from the peripheral countries to Spain, one of the eurozone’s largest economies (making Italy more vulnerable). The problems are getting more serious and difficult to resolve. As the result, the desire of the eurozone to remain united is colliding with the weaker members’ reluctance to enact the necessary structural reforms.

Markets Begin to Price in a Potential Disorderly Greek Exit from the Eurozone

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In May, following the Greeks’ inability to form any sort of coalition government, the market began to price in the risks related to the follow-on Greek elections (to be held June 17th), including the possibility of a disorderly Greek exit from the euro. Bank stocks, which continue to be a barometer of macro risk, felt the impact, with the U.S. and Canadian banks declining 8.7% (BKX) and 5.9% (STDBNK Index), respectively. CDS spreads widened, with those for Spain and Italy rising ~25% on average, reflecting their growing risks.   

Until recently, the market has assumed that should a country (i.e., Greece) attempt to leave or be ejected from the eurozone, this potential event would not occur for several years, and, as a result, the process would likely be orderly. This assumption appeared to be in keeping with policymakers’ “kick the can down the road” strategy, intended to buy time for the recapitalization of the continent’s banking system and the enactment of serious budgetary/fiscal reforms. This strategy is particularly important for the two largest countries at risk, Spain and Italy, which are, collectively, too big to save.

By denying the pro-bailout parties the ability to form a government in the May 6th election, Greek voters have short-circuited the “kick the can down the road” strategy. Effectively, they have used the electoral process to express their opposition to the austerity necessary to continue to receive aid. They are perhaps betting that voting for Syriza (the radical left, anti-bailout party that placed second in the May 6th election) may induce the Troika (i.e., European Commission, International Monetary Fund, and the European Central Bank) to relax the austerity conditions, which they perceive to be too harsh.

On June 17th, should the anti-bailout parties form the next government, or the pro-bailout parties be prevented from forming a governing coalition, the Troika  will likely be forced to determine in the very short-term just how far it is prepared to go to keep Greece in the euro (a process clearly constrained by public opinion in Germany). Although the election outcome is impossible to predict, the market clearly hopes that the Greek voters do not ultimately push the crisis to the brink, by refusing to honour the bailout conditions, and thus, testing the eurozone’s resolve to continue aid.

Spanish Banking Crisis Adds to Market Stress

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Adding to the already high macro risk is the fact that Spain is in the midst of a full-blown banking crisis, caused by the bursting of its real estate bubble in recent years and the huge credit losses yet to be recognized. The possible losses in the sector are likely too large for the Spanish government to fund a recapitalization program. In fact, Merrill Lynch estimates the Spanish banking system could have a capital shortfall of over €60 bln, an amount that would necessitate the government to ask the eurozone for assistance.

Somewhat ominously, the ECB reported that Spanish banks were beginning to experience deposit outflows, although the reported amounts are – for now – modest (€31.4 bln versus €1.6T in total deposits; Source: ECB). This followed substantial outflows from the Greek banks raising fears of large-scale bank runs across the Eurozone.

European Policymakers Have Prevented Events from Getting Out of Control (So Far)

During the Credit Crisis, U.S. policymakers were consistently playing catch-up. Time and time again, their failure to understand the seriousness of events eventually culminated into a full blown crisis. It was not until the crisis reached its apex in the fall of 2008 (with the market bottoming in the spring of 2009) that policymakers began to seriously consider the necessary solution, i.e., the nationalization of losses within the banking system and GSEs.

By contrast, an argument can be made that European policymakers learned from the credit crisis and are at least keeping pace. This is not to say there have not been great failures on the part of European policymakers (there have been). Rather, it is to acknowledge that they have – so far – been able to prevent events from getting out of control (even if only barely). 

For example, the EFSF (European Financial Stability Facility) prevented a rapid series of defaults resulting from the bond market closing to vulnerable countries (i.e., analogous to the LDC Debt Crisis, which started with Mexico in 1982 and saw 40 countries in arrears on interest just four months later; Source, FDIC). The ECB bond buying program helped bring liquidity to the debt markets, lowering sovereign debt spreads, albeit temporarily. Crucially, the LTRO (Long-Term Refinancing Operations) program prevented a full-fledged banking crisis (via liquidity-driven banking failures), by providing funding directly to cash-strapped European banks, which rely so heavily on wholesale funding (in contrast to the more stable core deposit funding typical of North American banks).

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Trying to Get Back to “Kicking the Can Down the Road”

So, if Greece elects an anti-bailout party, how will policymakers react? We do not see the Troika giving in to Greece’s anti-bailout party’s more extreme demands – the political environment in the northern countries would make that exceptionally difficult. Based on market commentary and news reports, it appears that four major policy responses are being contemplated.

First, the implementation of a eurozone bank deposit guarantee, which would reduce the possibility of a full scale banking crisis and the spread of contagion. This would require some concessions regarding a continent-wide bank regulator. Second, a limited eurobond backed by each country’s gold reserves. This has the greatest potential to significantly downgrade the seriousness of the crisis, as it would reduce the potential for a series of sovereign defaults.

Third, it is also possible that some form of pan-European fiscal pact arises, as the more vulnerable countries agree to cede some budget sovereignty in order to receive more immediate aid (although such devolution of power to Brussels is surely to be tested in future elections). Fourth, despite German opposition, the ECB could enact quantitative easing, which, given its unlimited buying power, would drive bond yields down and lower financing rates for vulnerable countries (and no doubt, push the price of gold higher).

All of these measures would be welcomed by the market. With the exception of quantitative easing, all involve some form of partial structural reform. It is worth noting that the stronger eurozone members have continually shown willingness to compromise for the sake of preserving the union, increasing the probability that some or all of these measures are adopted.

Resolve to Preserve Union Colliding with Resistance to Structural Reform

Importantly, at each stage of this crisis, the deterioration of events has consistently been met with a counter-response by policymakers. As a result, a Greek exit from the eurozone in the short-term is far from certain, and investors should not underestimate the resolve of the members to prevent a break-up.

Unfortunately, this desire to preserve the union is colliding with the resistance of member countries to enact necessary labour and fiscal reform to allow the most indebted countries to get their debt/deficits under control and truly end the crisis. This brings us back to the current strategy, “kicking the can down the road”, which ultimately only works if two conditions are met: (1) the time “bought” is actually used to fix the problem – in this case, the GIIPS countries enacting structural fiscal and labour reforms; and (2) everyone agrees with this strategy. Unfortunately, within the eurozone, neither of these conditions is met at the moment.

And that is worrisome.

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