Strong enough to blow up

“The existing political union may be too strong to blow up, but it is also too weak to function properly’’ – Wolfgang Munchau

Last week one of the matters discussed was the substantially reduced risk of an immediate eurozone breakup. This follows European Central Bank interventions such as the OMT (Outright Monetary Transactions) programme. We also acknowledge that intra-EU tensions have not gone away, and the ECB can at best buy time for them to be addressed. Until such time, what is currently unthinkable could still (eventually) happen.

Beyond the sanitised world of economic numbers, there is a very real human cost to the eurozone crisis. However, it is a cost which is not spread evenly throughout the eurozone. For example, while German unemployment has been dropping like a stone, unemployment in Spain and Italy (the two major distressed countries) are on a clear upward path.

In contrast to the positive developments seen in the countries’ bond yields, on this measure things are not only bad, but getting worse. The tensions are being increasingly concentrated, not dispersed.

EU members often have an inward-looking predisposition, with a tendency to measure themselves against other member states. That is perhaps just as well, since the EU does not compare favourably with other major economic blocs on a number of measures.

Both the intra-EU gaps and the gaps opening up between the EU and other economic blocs are a direct result of EU policy. Policy changes could certainly initiate an economic turnaround. However, political considerations are dictating otherwise.

Pimco’s Anthony Crescenzi has coined the phrase ‘the Keynesian endpoint’ – the point where governments can no longer stimulate and rescue their economies through increased government spending due to endemic levels of pre-existing government debt. Is there such a thing as ‘the Barroso endpoint’, the point at which the EU political class can no longer exert its will against the best interests of the EU population?

One can categorise the arguments against eurozone breakup into two main camps. The political ideology argument has been well documented – political fanatics are blind to the idea that a change of strategy should be considered, much less implemented. We need not take account of their standpoint any more than they take account of anyone else’s.

The more balanced camp has appraised the merits and demerits of a eurozone breakup, and has concluded (so far, at least) that the demerits outweigh the merits. However, one of the main reasons why the demerits outweigh has a negative basis – that a eurozone breakup will lead to a banking crisis. It is not that breakup is a negative in itself, but what it would lead to due to a systemic risk built up by banks holding the debt of insolvent sovereigns.

In that context, it is interesting to note how banks have been aggressively reining in their exposure to eurozone sovereign debt. Let us take Greece as an example. At the end of 2010, European banks held $52 billion of Greek sovereign debt. That represented 96 per cent of the total. As at September 2012, European banks held a mere $4 billion. Greece is by no means an isolated example – the same trends are apparent across the whole PIIGS group: Portugal, Ireland, Italy, Greece and Spain.

In aggregate, European banks had an exposure of $217 billion to this group in September – a remarkable turnaround, especially in the context of falling yields. We note that European banks become an increasingly attractive investment proposition as they reduce their exposure to European sovereign debt. Hardliners in Germany will also note the shift in the balance of power between debtor and creditor – where once Greece had an ace up its sleeve in the form of contagion risk, that risk is one which Germany can increasingly contemplate taking on, especially against the alternative risk of having Greece constantly on the drip.

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Curmi & Partners Ltd is a member of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.

Martin Webster is head of equity research at Curmi and Partners Ltd.