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Europe’s Last Resort

William De Vijlder, CIO, Strategy & partners, BNP Paribas, says that Europe’s problem is more of allocation of savings…

In the European Union, the problem is not one of total savings, since the EU has a current account surplus. The problem is more of allocation of savings. If a lender of last resort could be found, then the problem could be solved, and that too without incurring a very significant cost, says William De Vijlder, chief investment officer, strategy and partners, BNP Paribas Investment Partners, in an interview with our editor, Dhirendra Kumar.

What are your views on recent events in Italy and the evolution of the euro zone debt crisis?
The euro zone crisis is combination of two things. One, because of what has been called the great recession, public-sector finances in several countries have come under pressure. And that has gradually spilled over from the weakest countries to others.
That has to be seen vis-a-vis another question: how fast can the euro area grow? Why is this a key question? Because, one, over the years there have been differences in the economic performances of European countries. Some have become more competitive, having grown faster, and others have become less so.
The second reason why the growth dimension is important is that when you look at the evolution of debt to GDP, there are two important parameters to be looked at: one, how expensive is your debt? And second, how fast can you grow? So then people start to wonder what really is that growth rate? If at the same time interest rates go up, then people start to worry. That has been the case with Greece and Italy as well.

Then you will ask me: why is it spreading from one country to another? The reason is that you have the realisation now that the risk attached to investment in euro zone debt is actually higher than people thought until 2008. And that is a new element. So people are now reassessing the structural risk of these countries. That explains why the crisis is gradually moving from one country to another.
In addition, you have to account for a negative feedback loop, i.e., the fiscal deficit goes up, then the spreads grow, then banks’ share prices come under pressure, that leads to worries that growth in credit supply will decline, that leads to worries about economic growth, which in turn has a negative impact on expected fiscal deficit, which puts up interest rates, and so on. You can continue going round in circles.

How about the situation in Italy?
Market pressure has built up on Italy and there is pressure for change. So Prime Minister Berlusconi decided that provided the savings plan that he had put forward in Parliament is accepted, he will step back, which he did, and now we have a new government. It’s a government led by former European Union commissioner Mario Monti, a man of high expertise. He has a time window that is relatively long since the elections are only in 2013.
Now, will the markets give him time, considering the pressure that has built up and is intensifying? If you look at the bond auctions that took place in Spain earlier this week, yields went up again.
A lot of the market pressure has to be seen in relation to the fact that at the most recent summit it was announced that the European Financial Stability Facility (EFSF) would be levered to one trillion euros. But it is not yet clear how exactly it will be done. That led to market disappointment.

To my mind, a lot of people are underestimating the level of determination that European political leaders have in eventually solving this. People tend to take the matter of divorce too lightly. They say that if in a household a man and his wife have been living together for a number of years and then they have tensions, they should separate. In this case it’s slightly more complex because the economic consequences of such a profound change will be fairly disruptive. So political leaders are exploring ways of addressing this, and they do face a few constraints. One constraint is the governing law of the European Central Bank (ECB) that does not allow it to do quantitative easing, as the Americans and the British did.
If you look at recent information flows, the effort to look for a solution is going on. What you need ultimately is a buyer of last resort. You have to look at the problem from two angles: what is the being done in terms of measures, and then what is the market reaction? In terms of measures taken, Greece, Italy, Portugal and Spain have taken fairly radical measures. Spain has written in its constitution that it needs to have a balanced budget by the end of this decade. France has taken two successive measures to pull back the budget deficit.
The markets, however, are not buying into these measures. They are saying that if you take these measures, you will have a recession. But if the markets were to think one step further, they should say that yes we would have a recession. But these measures will pay off and as a consequence interest rates will go down, and that will be very helpful.

The problem that we have is also one of credibility. The markets are sceptical that these measures will be implemented over the long term. That’s why you have increased peer group monitoring taking place among the euro zone members. Peer group monitoring is important because it enhances credibility. With the troika of the ECB, the European Union and the IMF coming in, you have credibility enhancement. Putting things into the constitution again enhances credibility.
But the markets are impatient — they want to have their cake and also eat it. Because they are impatient and can create pressure, it becomes important to find a buyer of last resort. If you do that then you have an ideal combination. On the one hand, all these measures are being implemented. Alongside if the private sector in not willing to buy these bonds, then if there is a buyer of last resort that will push back bond yields. As the effects of these measures become visible, it will accelerate the return of market confidence. So this will be the plan. The focus will now be on taking these measures, having peer group monitoring, and then finding a buyer of last resort.
I was reading on the website of Financial Times that there are now rumours about discussion that perhaps the ECB could provide funding to the IMF and then the IMF could step in. Well, that is one of the possibilities. But I am mentioning this as an example of the degree of determination that exists to address this problem.
Now once this problem is successfully addressed, then it goes without saying that it will be a sea change for the markets. It is striking that wherever you travel — Canada, the US — the number of questions you get on the euro zone. Previously nobody bothered. Even in India when you look at the financial TV stations, it’s all about the euro zone. Yesterday I met officials at the Reserve Bank of India (RBI) and they too talked about the euro zone. Risk appetite in the markets has sunk very low due to understandable reasons. If we manage to get this right, it will bring big changes to the markets across the globe. But when this is going to happen, I don’t know.

Did you visualise this happening?
I don’t know. There are only two observations you can make: one, market pressure has gone up and continues to rise. It reinforced my view that as investors we must invest more time on what I would call extreme-case scenario analysis. Typically people think of the base scenario and of some alternatives. You have to say: let’s take an extreme scenario and think it through because that will help you anticipate and identify when you are going there.
To answer your question, I was participating in a dinner in December 2009 organised by an investment bank. It was one week after Greece had grabbed the headlines by saying that we have looked at the public sector deficit data and they are not really that reliable. The view of the investment bank and also of the people around the table was that it’s a single-country issue and it will not spread out. Now the reason it has spread needs to be linked to the overall feeling that the recovery from the great recession was taking more time than one earlier thought it would. The second element is that it made people think: with the benefit of hindsight, Greece’s risk was not priced correctly. That made people think about other countries as well.
There is a new theory on analysing contagion that is fairly revealing. When you think about a contagion, typically the analysis grows as follows: one country can contaminate another if it has a trade balance or capital flows. A new development in that analysis is when investors make mistakes on specific countries. That increases their uncertainty level, so they start to doubt the validity of other forecasts. They say: if we got Greece wrong, is there a chance that we will get other countries wrong? Doubting one’s own forecast can create uncertainty which in itself can lead to a contagion. That is what we are seeing in the euro zone.