The importance of being earnest, about the Eurozone in general and the Euro in particular

The Unknown
As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don't know
We don't know.

—Donald Rumsfeld, Feb. 12, 2002, Department of Defense news briefing

Another change in perception this week, to follow up on my article about the Dubai mirage. This time, Greece in particular and the Eurozone in general!

On Tuesday, Fitch Ratings Inc. cut Greece's rating to BBB+ with a negative outlook and it unnerved the markets.

Markets once again have a short memory. BBB+ was the rating for Greece before the introduction of the Euro in 1999.

http://www.fitchratings.com/shared/sovereign_ratings_history.pdf

Greece managed to fiddle with its stats to get in the Eurozone and benefited from the cheap funding available to all members of the coveted Euro currency. We all know what happened to Spain, cheap funding generated a massive real estate bubble and when it went tumbling down Spain's employment rates went through the roof (Spain unemployment level will rise to 22% in 2010 and some Spanish regional banks are still sitting on hefty losses). Eastern European citizens also played a dangerous game, borrowing in Euros or CHF. All these "cheap" loans went badly wrong when Eastern European currencies had to be devalued as the GDP in these countries dropped like a stone.

As any form of peg, the Euro, although a safe haven for many, has now become some countries worse nightmare. As Greece cheated it's way it, Greece is now facing great troubles as it cannot cheat its way out by massively devaluing its currency and reduce therefore the debt to GDP percentage which currently stands at 110%.

Greece 5 year CDS (232.19 Bps on the 5 year point, source CMA DataVision) is now trading above Turkey 5 year CDS and the spread of Greek debt versus 10 years German Government bonds (Bund) is trading at level not seen since 1999...

I remember a conversation I had with a trader back in 2005, about the spread between 10 years German Bund and 10 years Italian BTP. At some point the spread between both was around 22 bps. This was abnormally tight and at the time I thought it was a fantastic bet to put on and a very simple one: betting that the spread would go back to where it was before the introduction of the Euro, above 120 bps. It did happen. Now the spread has come back to the 60bps level. I don't think that in the near future it will stay there.

The virtues of joining a single currency doesn't coincide with the vices of some European governments, who issued more debt and ran larger and larger budget deficits. It is a game you cannot play forever unless you can devalue and make your own citizens poorer in the process, which used to be a regular tool used by Italy before joining the Euro.

When I hear Mrs Christine Lagarde saying the following: 'I don't think Greece could go bankrupt,' on RMC radio. I have to disagree.

David Einhorn, who is President of Greenlight Capital, was cited in a recent letter published by John Mauldin' in the excellent "Outside the box" on the 26th of October
Here is an excellent quote relating to Mrs Lagarde foolish statement: "To slightly modify Alexis de Tocqueville: Events can move from the impossible to the inevitable without ever stopping at the probable."

Even France is increasingly at risk. The last time France had a balanced budget was in 1980. Since then, the government has been spending more than it has been collecting and the service of the external debt (payments of the interest only), is not even covered by the receipts coming from the income tax.

As per a Reuter article published today:

http://in.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idINGEE5B80FO20091209

She also said that French debt was popular in financial markets but France would continue to take care to ensure that there was not threat to its credibility.

"By comparison to our partners we are very well rated," Lagarde said. "So France's signature is good. The market likes our paper and we are extremely determined to be very careful to the way we issue."

Asked about the potential size of a new loan that President Nicolas Sarkozy is planning to fund investment projects, Lagarde said: "It must be a figure which does not raise questions about the quality of France's debt signature."
It is once again all about maintaining at all cost perception that everything is fine.

Well, things are not fine.

Because of the euro, governments cannot cheat at the moment by devaluing their currency. France had three devaluations in 1983 as a reminder.

Italy used to regularly devalue the Lira before the introduction of the Euro.

Could Greece or Italy leave the Euro?

For those who would like to evaluate the probability of this event, please find enclosed the link to two very good articles:

One written by Nouriel Roubini on the subject in 2005.

http://www.rgemonitor.com/roubini-monitor/92824/what_happens_if_italy_dumps_emu_and_the_euro_devaluation_default_and_lira-lization_of_euro_debts

The other I recommend reading is the excellent article written by Macro Research House Gavekal on the subject written as well in 2005.

http://gavekal.com/dforum/attach.aspx/51/divorceitallianstyle.pdf

For those who would like to track sovereign risk in the CDS markets, please use the following useful link:

http://cmavision.com/market-data/#riskiest

The CDS market is a good indicator of the perception of risk for both corporate risk as well as sovereign risk.

It is also a very good indicator of possible movements in the equity markets. The equity market took many months to react to the widening of the CDS markets which started in August 2007, following the blow out of the two Bear Stearns Structured Credit Funds, which marked the beginning of the subprime crisis.

We have moved from a financial crisis to an economic crisis and now a sovereign crisis.

To conclude:

Yes, countries can go bankrupt and can go from being very rich to very serious distress. Markets have short memory, and so do Finance ministers...and particularly French ones as well.

Maybe Mrs Lagarde should study the history of Argentina which increased in prosperity and prominence between 1880 and 1929, and emerged as one of the 10 richest countries in the world at the time before completely crumbling down.

In our next episode we will revisit my central theme about perception and facts about the current economic situation.

I will leave you with a final quote from the movie The Matrix from 1999, year of the Euro as an appetizer for my following post

Morpheus: This is your last chance. After this, there is no turning back. You take the blue pill - the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill - you stay in Wonderland and I show you how deep the rabbit-hole goes.