DAVID PAGE, CFP. CSA. CDFA.
Sr. Exec. Financial Consultant
Europe...A Long Way from Home
Europe’s debt challenges –will take time to work out
The Euro region is currently experiencing a complex sovereign debt crisis, which is centered around Greece and the potential of a debt default. Greece’s debtto- GDP (Gross Domestic Product) ratio is likely to be at least 160% by the end of 2011—or the equivalent of an individual with a $50,000 income, burdened by a debt level of some $80,000.
It is clear that Greece cannot afford to make their interest payments based on their current interest rates and consequently, financial markets have been speculating for some time about the likelihood of a default. Above all else, financial markets dislike uncertainty, and would welcome any resolution to the situation.
What has happened?
It’s important to note that the financial turmoil in Europe is no longer confined to the smaller peripheral economies like Greece. It has spread to countries such as Spain, Italy and France, and where regional banks have seen a significant decline in their share prices due to concerns about their exposure to the weaker countries’ sovereign debt (Greece in particular but also Italy, Portugal and Ireland) and where interest costs have also risen substantially. With the contagion spreading, the crisis has become a Euro wide crisis.
The Euro region does not have a common fiscal policy. As a result, there are 17 separate European countries with different fiscal and taxation policies and clearly different priorities. For comparative purposes, although in Canada we have 10 separate provinces, we also have a federal taxation and transfer payment system which acts as a balancing mechanism to smooth out differences in the economic situation of each province. No such mechanism exists in Europe currently.
The Eurozone is unique in that it lacks a centralized or overarching government and is as a result a collective of separately governed countries, with different fiscal and taxation policies who happen to share a currency, which creates a lack of political cohesion and creates a whole subset of additional and unique challenges.
At the time of this writing, agreement on the terms of a new bailout is being completed. Right now, the core countries of Europe, led by Germany, are insisting that Greece and the other peripheral countries such as Ireland, Portugal, Italy, and Spain pursue fiscal austerity measures such as cutting public expenditures and raising taxation levels to reduce their budget deficits. These austerity measures are having a very negative impact on the domestic economies of these countries and have been resisted strongly, particularly in Greece. As a result of these austerity measures, the debt position of Greece relative to its GDP is likely to worsen in 2011 as its economy declines by at least 5.5%.
Will the Euro survive?
It is largely expected that the Euro as a currency will survive, because the cost of its dissolution or any one individual country exiting the Eurozone are simply too high. Some analysis shows that the cost of a fiscally weaker country like Greece leaving the Euro could be as high as 40-50% of its GDP in the first year.
However, the decision also has political implications, and in order for the Euro to survive longer term in its current form, the creation of a fiscal union, which could include a common Eurobond, is likely an outcome. Presently there is no mechanism for a country to be expelled from the Euro, although a country wishing to leave can apply to leave, subject to legislation and treaties of the 27 European Union member countries. Any country that leaves the Euro, while enduring the protracted process of negotiation is likely to experience severe problems such as bank runs, sovereign default, corporate default, and perhaps even social unrest. Additionally, the costs of Greece exiting the Eurozone would be prohibitive. The International Monetary Fund indicates that Euro banks would see a hit of close to $200 billion euro (roughly $276 billion U.S. if these probabilities were realized, due to the fact that Greece is fully integrated into the rest of Europe’s finances.
The Euro can survive, but the task of saving it has been made more difficult by the lack of political cohesion and policy mistakes by the European Central Bank, such as increasing interest rates prematurely. The best case scenario is an orderly Greek default without any contagion to Italy and Spain and this can best be achieved by a successful re-capitalization of the banks to restore confidence.
It is inevitable that the Euro region will move slowly towards greater fiscal integration and greater fiscal discipline. Such a move would improve Europe’s competitiveness and reduce its debt burden. It is also likely that financial markets will have a greater degree of certainty by the end of this year than they do right now.
The portfolio management team at I.G. Investment Management, Ltd., continues to monitor the situation in Europe and remains focused on long-term opportunities and also adhering to stringent processes and disciplines. This includes reducing holdings where it makes sense to do so, and increasing holdings that are defensively positioned or in regions and sectors that look undervalued relative to their fundamentals.
Written and published by Investors Group as a general source of information only. It is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax, legal or investment advice. Readers should seek advice on their specific circumstances from an Investors Group Consultant.
David W. Page is a Kamloops rider who is very active in his
community and is a member of the RFBA
Phone: (250) 372-2955 Toll Free: 1-800-897-9559
Fax: (250) 372-1567