Lebensraum: Germany has finally found it, although not quite the way they imagined it. Today, Europe is at its feet, except that maybe, Germany has no reason to want it there. Over the last year, we have all been focusing on the US. Much of the news has been about US equities, the effects the banks have had on stock markets, and the effects that mortgage markets have had on the banks. European banks were seen to be heavily exposed to the US, but that was it.
But life is not yet finished with its twists and turns. The story shifts this year to a different canvas: one, it is no longer about the banks that threatened to go down the drain, but the countries that have put up their hands for help. Two, the mayhem has shifted from the equity markets to the much larger currency markets. More important, if you were inactive in the equity markets, you might have escaped the terror of last year, but there is no escaping the potential Armageddon if the currency markets deliver a contagion.
If you look at the recent chart of the Euro, it looks remarkably like the Dow (or the Nifty) in October-November, 2008. Yet it is not such big news, at least here in India. Either we have grown inured to such things, or we do not realise its significance. For starters, this (the Euro) was the place where people were looking to flee. And as the cockroaches come out of the woodwork, we need to pause and think: in this headlong flight out of the US dollar, have we stopped to think just where we are going? I mean, the US has huge problems (no doubt), but it also has the most resilient economy in the world, besides the courage and culture that encourages 'creative destruction'.
Take a look at just where people have been running to: they have bid up the Euro to 1.5 times the real value of the dollar, simply because interest rates were held up by the European Central Bank (ECB). And on average, the Eurozone has been contracting at 4 per cent, with an average Budget deficit going from 6.9 per cent to 7.5 per cent, even as average government deficit is 84 per cent of GDP (even India is doing better). More important, the deficits will take government debt up another 22 per cent of GDP, before they peak, leaving them paying 3.4 per cent of their GDP as interest cost, or about 10 per cent of their revenues.
The only solvent country: Germany contributes 20 per cent of the Eurozone GDP, but its $2.8 trillion GDP is made up of 45 per cent exports (of which 47% is industrial, machinery 27% and auto exports, 19%). Its 4 per cent Budget deficit is also lesser than the average Eurozone's, and much lesser than the rest of the world. Given the nature of its price-inelastic exports, it will be the first country to rebound if global recovery picks up.
But look at the other countries: their GDP is shrinking at between 5-7 per cent, Fiscal deficits exploding from 3-12 per cent, debt:GDP ratios all above 60-120 per cent and interest already at 10 per cent of government revenues. With no space to increase their total stock of debt relative to a shrinking GDP, their income is already stagnant or falling. Yet, the taking on of the debt burden of their recalcitrant (and truant) banks, is creating for these countries a bankruptcy trap. As these governments step in to support their failing economies with stimulus plans or bailouts of their citizen banks, they are really funding holes in balance sheets. This has to be paid for by current savers, who are bridging the gap between today and the tax flows of future generations. These savers are no longer a kindly lot, especially after their recent experience with the US. They are demanding huge belt-tightening measures like the one mandating Greece to drop its fiscal deficit below 8 per cent, from the existing 12 per cent.
The normal bankruptcy ratio is a combination of these metrics: the boundaries are set by Interest Rates, GDP growth rates, fiscal deficits, debt:GDP ratios, tax:GDP ratios and interest:government revenue ratios. The last is really derived from the given set of numbers. The independent variables are really GDP growth rates, indebtedness and tax ratios. At 20 per cent of government revenues, interest is into the red zone. This, combined with the fiscal deficit, decides the debt trap. At one time, the government finds itself borrowing just to pay interest. When this happens on external account, the government is officially declared bankrupt.
Japan, India and other Asian countries with high savings rates, have got into internal debt traps before, but if they have borrowed from their own people, they can always monetise away their liabilities. It does not get to be called a bankruptcy. But governments cannot print foreign-exchange, which is why they have to declare bankruptcy, or resort to IMF protection.
If Europe as a whole is largely falling into this trap, the only country capable of any bailout is Germany. And with just 20 per cent of European GDP, that is simply not large enough to make a difference. What's more, it also has to decide whether it wants to remain part of a rag-tag set of countries that have spent themselves into oblivion.
If Europe holds together, it must tighten its belt, which minor nations are loathe to do. Pressure building up in Europe between those who save and those who borrow, could tear Eurozone apart. Germany has to decide whether Europe, as an ideal, is worth pursuing at the cost of its economic well-being. And if the free lunch ends, and it is time to pay back, the minor nations who came in looking for soft interest rates riding on the back of German (current account) surpluses and savings rates, will choose to go their way… if they can.
This is not a mess that will sort itself out any time soon, Nor is it linked to the sub-prime mess that America is going through. This is an independent event, linked to the 'unification' of Europe, where different nations meet at the high table called Europe, but for different objectives.
But certainly, this (situation in Europe) is hardly the kind of stuff that makes for a relative value of 1.5 times the value of the dollar. It could well be touch-and-go, as to who is in better shape, the US or Europe, with Japan in the distinct third rank. Broadly, if I had to punt on direction rather than any fixed destination, I would sell both the JPY and the Euro against the dollar. Not only do both these competing economies seem to be in worse shape than the US, it is well established that their intrinsic and structural ability to come back is decidedly inferior to that of the US. And if the currencies follow their respective economies, then that is where I rest my case.
All this does not augur well for the currency markets. If the 'safe haven' currency has proved to be such a disappointment, there seems to be nowhere to go. While this might make a case for the gold bulls again, I am coming round to the view that gold might prove to be a temporary safe haven, even while the world looks around for a well-managed country/currency that proves itself worthy of its trust. Till then, gold will be a temporary parking slot, but not a permanent one.
Can nobody else see it? How about India as the next safe haven? ... we have once been jocularly called a 'gold ETF', given the underlying $200 billion of gold lying under a billion mattresses. This time, how about our RBI being the most trusted central bank in the world? … after Greenspan, not much competition in that department.
I know it runs against everything I have said before, but there is a scenario that we might (temporarily) become a safe haven for currency markets. Temporarily, I say, because the Government of India is bound to misuse its new found credibility, maybe take over the RBI, if needed.
But it would be something to watch out for!
This article was originally published on April 17, 2010.
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