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Analysts are trying to determine which type of failure would cause less damage to the euro zone
Gail MarksJarvis
17 September 2011
If you were going to save Greece or European banks, which would you pick?
That’s the debate in Europe, as analysts try to determine which type of failure would be less injurious to Europe and, ultimately, the global economy. Until now, euro zone leaders focused on saving Greece, but increasingly it’s looking like a losing battle.
“It seems the Germans have reached their limit,” said Luz Padilla, portfolio manager for the DoubleLine emerging-markets fixed-income fund.
So the speculation is that Greece will default on its debt payments within the next three to 12 months. Rather than risk throwing good money after bad, some analysts say, healthier European countries that have been helping Greece will instead let Greece default. Then, the strong presumably would mop up, throwing money into European banks and bolstering Italy and Spain to keep the core of the euro zone.
Banks across Europe hold debt from troubled nations, including Greece. So in a default, banks would have to write down the debt, their financial condition would weaken, and some are expected to require some kind of government support.
While European banks are more exposed than those in the US, analysts think there will be some impact in America too because the institutions are linked through loans and other transactions. US bank exposure, however, is expected to be restrained if Europe amputates the weakest limbs, such as Greece, and saves the core that includes Italy, Spain and France.
While it’s not the official stance of any country, attention is focusing on what’s being called an “orderly” insolvency. In other words, the question is whether debt problems in Greece, Portugal and Ireland can unravel without too much contamination to stronger European countries and global banks.
Investors, of course, worry about unintended consequences. Beyond loans, financial institutions are linked through derivative contracts, which have not been quantified. Given the severe credit crunch after Lehman Brothers’ collapse, it’s conceivable that nervous institutions would try to insulate themselves from the unknown by freezing lending. Since Europe and the US are close to recession, a credit crunch would undermine economies further.
Investors are likely to pin their hopes on World Bank-IMF meetings involving US and European officials from September 23 to 25. On Monday, markets turned higher when a rumour circulated that China was going to buy Italian bonds, help Italy requires because squeamish investors have been reluctant to provide the funds at manageable interest rates.
“So this is what the equity market needs these days to hold support: meetings, speeches, summits and, now, rumour and innuendo,” Gluskin Sheff economist David Rosenberg said on Tuesday.
European markets rose on Wednesday before an evening conference call with European leaders.
Rosenberg said the rumours and the nervousness “is highly reminiscent of what we saw take hold in 2007. This is no time to engage in denial; acceptance will do better to preserve your capital”.
While Merkel said she wouldn’t let Greece enter into “uncontrolled insolvency”, Rosenberg noted that “nobody knows what that would look like, since there is no mechanism within the euro area to deal with a sovereign debt default”.
Meanwhile, others think investors are overreacting. “While the crisis-management framework seems insufficient, concerns around the European financial situation seem overblown given current conditions,” Barclays strategist Barry Knapp said.
Still, a majority of European fund managers surveyed this month by Bank of America Merrill Lynch are expecting a recession, and their confidence is at the lowest point since Merrill’s March 2009 survey.
Although they are in a fairly glum mood, Merrill strategists have said that extremes in their monthly surveys can point to opposite market conditions.
If that is correct in this case, the fact that managers are holding defensive stocks and more cash than usual should point to better returns in stocks. But 65 per cent are expecting the European economy and profits to weaken over the coming year.
And if conditions weaken further, they assume emerging-market stocks and commodities will be the most vulnerable.
McClatchy-Tribune