Notes From Poland: Eurozone Showdown

This second note on the Global Interdependence Center's gathering a week ago in Poland of central bank governors, economists, and financial experts is being written in the sun-drenched beauty of the Provence region of France. The turmoil of Europe’s financial markets and the hardships being experienced by the weaker European economies seem remote until one picks up the Financial Times or turns on the TV to Bloomberg or CNBC. It has been a distressing week, ending a depressing month. In just a few days, concerns about a possible exit of Greece (“Grexit”) have been pushed aside by "Spanic" – panic about Spain.

The discussions in Poland had a more upbeat tone than probably would have been the case had they been held a week later. A common view was that the Eurosystem would survive, with or without Greece. The monetary union was a political creation, and the core countries were strongly committed to it. They would (eventually) do what was necessary for the system's survival. A week later we had the president of the European Central Bank, Mario Draghi, warning that the Eurosystem's structure had become "unsustainable." This strong language was aimed at getting Europe's political leaders to move soon to take bold action. The situation clearly was deteriorating swiftly.

Participants in the discussions in Poland did put emphasis on the need for decisive action by European governments to deal with their problem banks. This is the central problem now facing the Spanish government. As one central bank governor said, "As long as they are reluctant to do so, the problems remain and in the end there will be no alternative but to deal with them."  Banks in the countries represented at the conference are reportedly in pretty good shape currently, but they would not be immune from a deeper recession in the Eurozone and pronounced deleveraging by Eurozone banks.

In testimony to the European Parliament last week, ECB's Draghi also emphasized the need for prompt action to protect the Eurozone’s banking system. He called for a "banking union" to protect depositors and deal with failed banks in a way that protects the system. He noted, correctly in our view, that when banks encounter serious problems, bank regulators typically "underestimate the problem and then come out with a second or third or fourth assessment." In the end, the needed actions are taken; but due to the delays, the costs are unnecessarily high. "That's the worst possible way of doing things," he said. He cited as an example the muddled way the problems at Spain's Banka bank have been addressed thus far. As was stated at the conference, any move to unified banking regulation in Europe needs to be coupled with a unified bank deposit-insurance system and lender of last resort responsibility for the European Central Bank.

Global bond markets evidently lost confidence last week that European policy makers are going to act swiftly and in a convincing manner. A flight to safer havens accelerated, driving Germany's 2-year bond yields to zero for the first time ever. The US 10-year yield is at 1.47%, a rate not seen since 1946. The capital flight from Spain was already substantial in the first three months of the year. Spain's central bank revealed that a 97-billion-euro exodus of capital occurred in the first quarter. That number does not include the outflows that surely followed in April and May. The Spanish equity market has tumbled – the ishares ETF for Spain, EWP, dropped 29.4% this year by the end of May.

Spain's funding costs are now at levels that are widely thought to be unsustainable. Yields on Spanish 10-year government bonds rose above 6.7% at one point last week. The spread between Spanish 10-year yields and the yield of a basket of triple-A-rated European debt was at 470 basis points on Friday, a spread that could trigger additional margin requirements for banks using Spanish government debt as collateral. It is imperative that Spain act decisively and rapidly to restore investor confidence.

Spain was not the only factor depressing markets last week. The Italians had disappointing results from a debt sale and saw their borrowing costs rise above 6%. Data releases suggested that growth in the US economy, while still positive, remained rather weak; and the recession in much of Europe was getting worse. Global equity markets, as measured by the iShares global equity market ETF, ACWI, lost 9.7% in May.

There was one positive development over the weekend. The Irish voted “Yes” to the European Fiscal Compact and to the austerity that involves. Ireland has responded well to the challenge of its banking crisis and its equity market year-to-date is down only 6.9%, a quarter of the decline in the Eurozone as a whole.

We are concerned about the prospect of volatile international markets in the current period, perhaps extending through this summer, as the situation in Europe continues to depress the risk appetite of international investors. We have recently moved to a more defensive stance, raising cash in our International and Emerging Market portfolios and doubling the fixed-income allocation in our Global Multi-Asset Class portfolios. We continue to expect that eventually European governments and the European Central Bank will act to save the Eurosystem, probably in coordination with other central banks, including that of the US, and the IMF. Markets currently appear to be giving little weight to such an outcome. If and when that sentiment changes, the positive market reaction would likely be swift and substantial, particularly if there are indications the global recovery is accelerating. We will continue to monitor developments in Europe closely.

Postscript:  The last days of the GIC Conference were in Krakow, the cultural capital of Poland and major university center. It is one of the loveliest cities in Europe, well worth a visit. Unlike Warsaw, its many churches and other historical buildings escaped damage in World War II. In both cities we were deeply moved by the tales of outstanding courage in the face of cruel oppression by Hitler's Germany and Stalin's Russia.

Today in France we attended a service in the main church of a market town in Provence. The service happened to include the Confirmation of a number of bright-faced youth cloaked in white. As the congregation, to our surprise, sang "Amazing Grace" in French, we wondered about the future of these boys and girls. Will they be able to obtain jobs in the Europe of a decade hence when they leave university? And more important, will they be able to live their lives in a Europe free of wars, which was the underlying political motivation for creating the European economic and monetary union?