A day after the markets reacted to the trillion-dollar bailout plan for Europe, the markets gave back some of the gains. Is that just an entirely reasonable hangover from Monday’s wild party, or are investors genuinely having second thoughts about the package offered by the European Union (EU) and the International Monetary Fund (IMF)?
Isn’t $1 trillion (Rs45 trillion) enough? Almost everybody has said it is, for the short term. But almost everybody is also concerned that the liquidity support merely papers over the problem, that the political situation in southern Europe is not very conducive to fiscal prudence and banks will, sometime in the future, be forced to restructure their loans to Greece and possibly other vulnerable countries in southern Europe as well. In short, there’s a lot of scepticism about PIGS (Portugal, Ireland, Greece and Spain) flying. As a recent note from Deutsche Bank AG puts it, “Early favourable reception followed by renewed weakness has, however, been the pattern of both recent EU announcements, also the US experience in the early stages of the introduction of unconventional measures in the second half of 2008. And significant questions remain about the longer-term prospects of success—for instance, on the ability of countries under pressure to impose the fiscal austerity required.”
There are plenty of reasons to be concerned about the long-term implications of the bailout. One way of looking at it is to see it as the next stage of the continuing crisis of over-indebtedness. The over-leveraged private sector in developed nations was bailed out by their governments, which massively increased their fiscal deficits as a result. Private borrowing was replaced by public borrowing. The EU has now bailed out weaker governments by stronger ones. In other words, weaker public debt will now be replaced by stronger public debt. The logical question is: What will happen if appetite for the debt of stronger governments, too, slackens? As a very perceptive paper from the Bank for International Settlements (BIS) titled “The future of public debt: prospects and implications”, authored by Stephen G. Cecchetti, M.S. Mohanty and Fabrizio Zampolli, points out: “So far, at least, investors have continued to view government bonds as relatively safe. But bond traders are notoriously short-sighted, assuming they can get out before the storm hits: their time horizons are days or weeks, not years or decades. We take a longer and less benign view of current developments, arguing that the aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to boiling point.” And how on earth will governments curb their deficits without jeopardizing the recovery? After all, IMF has said that the recovery remains dependent on accommodative macroeconomic policies and has warned against tightening fiscal policies in the developed world too soon. Analysts are already warning about several years of low growth in Europe. The BIS paper cited above says, “It is essential that governments not be lulled into complacency by the ease with which they have financed their deficits thus far. In the aftermath of the financial crisis, the path of future output is likely to be permanently below where we thought it would be just several years ago. As a result, government revenues will be lower and expenditures higher, making consolidation even more difficult.”
But markets are more bothered about the short term. The EU bailout is being compared with the “shock and awe” treatment applied by US Federal Reserve chairman Ben Bernanke in 2008 after the collapse of Lehman Brothers Holdings Inc. And the great hope is that risk assets will rise again, just as they did after the Fed loosened its purse strings. The hope is that the European Central Bank (ECB) may be forced to open the floodgates of liquidity, although it has so far said that its purchases of dodgy government bonds will be sterilized. Analysts point out, though, that sooner or later they may be forced to abandon sterilization. As a Morgan Stanley report put it, “Overall, while fiscal policy might be on a more credible path, the biggest threat to the euro is now coming from monetary policy. We believe we are not far away from a point in time when the ECB starts printing and effectively monetizing euro area debt. We revert back to our ‘punish the printer’ theme, where quantitative easing remains negative for a currency.” But, just as the dollar fell earlier, that shouldn’t really matter. Exporters such as Germany will be very happy with a lower euro.
The question is: Will monetary easing by ECB have the same impact that the 2008 Fed easing had? There are major differences. There was no question of any fiscal austerity in the US. In fact, programmes such as cash-for-clunkers were specifically designed to put more money in the hands of people. As far as risk assets are concerned, there are several issues: one, equity valuations are much higher than they were in 2008; two, measures of risk appetite, too, are much higher; and finally, the Chinese markets are signalling a major slowdown. The Shanghai Composite Index is already off around 20% from its post-crisis high, which technically signals a new bear market in China. So the bailout is unlikely to result in another 2009 for risk assets. Hopes of new liquidity finding its way to high-growth emerging economies may be misplaced.
Far more important, though is Morgan Stanley’s Stephen Roach’s observation that the crises are getting more frequent and larger. That concern should outweigh the yearning for a liquidity fix.
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org