Tag Archives: Eurozone

Europhoria No More

In 2011 and 2012, the Eurozone was on the brink of destruction. Investors were preparing for a Greek exit from the Eurozone and some experts were even questioning the very existence of the European Union. However, in two years, much has changed. Today, the possibility of Greece leaving the Eurozone or of Cyprus becoming insolvent seems like a distant memory and after two years of being in recession, the Euro area has finally generated positive growth. The growth is slow, but is nevertheless positive.

How did the Eurozone manage this turnaround? Well, we can all thank the European Central Bank (ECB) for this. In July of 2012, ECB President Mario Draghi announced that the, “ECB would do whatever it takes to preserve the Euro.” In addition with this speech, the ECB extended the maturities on the loans it gave to European banks (called Long Term Refinancing Operations) and announced a new program (called Outright Monetary Transactions) where for the first time, it promised to purchase the sovereign bonds of financially troubled nations, given that they agree to implement certain fiscal reforms (tax hikes, spending cuts, etc.).

The ECB used a tricky monetary maneuver called sterilization to make sure that LTRO didn’t increase the European money supply the way FED’s QE did and until today, no country in the Eurozone has actually applied for a bailout through Outright Monetary Transactions. However, the mere existence of these programs created a sense of security in the Eurozone and they helped reduce the sovereign bond yields of Eurozone nations that had been inflicted by the crisis. For you bond newbies, the lower the interest rate on a bond, the less riskier it is deemed by the market. The graph below does a good job in visualizing Spanish and Italian bond yields in relation with ECB actions.

whatever_it_takes

In fact, one could argue that the sovereign bond yields of periphery Eurozone countries have dropped too low. For example, on the day that I have written this post, 10-year Spanish government bonds are yielding 2.68% whereas 10-year German bonds are yielding 1.27% . That means that the spread between the country with the highest unemployment rate in the developed world and the safest economy in the Eurozone is less than 2%. Back in August of 2012, that spread was about 6%. Even when Apple issued 10 year bonds in April of this year, their bonds yielded 3.45%. I think its safe to say that the markets have treated periphery Eurozone nations rather kindly.

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Despite the irregularities in the bond markets, its hard to deny that the Eurozone has been in a honeymoon period for the last two years. However I realized that something is rotten in the state of Denmark, France, Italy, Spain, and all the other Eurozone countries (that was a Shakespeare joke. Read a book people). when a couple of months ago, I got a phone call from my good friend Mario Draghi.

Mario Draghi
“Buddy, I need your help with something. Come on over quick. Party at Merkel’s place afterwards.”

Even though I had a very busy schedule, I couldn’t say no to one of my oldest friends. So I decided to take the trip down to Frankfurt. Here I am outside the ECB.

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I’ve lost count of how many times I’ve been there but I still have to go through security. Its so annoying. Anyway; when I walked into his office, Draghi seemed worried. He told me that the Eurozone is on the brink of negative inflation, otherwise know as deflation. The ECB’s target inflation rate has been 2% for the past several years. However, as the graph below shows, Euro area inflation has been below 1% since November of last year. In fact, just last month, several European countries including Greece, Cyprus and Hungary observed negative rates of inflation.

euro-area-inflation-cpi (2)Even those of us who haven’t received an education in economics have been told to fear inflation. However, deflation can be just as bad, if not worse. I’m pretty sure I explained this in a previous post but deflation has two main negative impacts. First of all, deflation discourages spending. Why should a sensible person purchase something today if he knows that it will be cheaper and more affordable tomorrow. This situation might seem profitable for an individual, but if everyone acts this way, then spending will decrease and the economy will come to a halt. Secondly, inflation has the ability to ease the cost of borrowing. Imagine that I take on a loan. Because of inflation, the amount of money I borrowed becomes less valuable. However, the amount that I borrowed stays the same. Thus, it becomes easier for me to pay back my loan. In cases of deflation when a currency gains in value, the exact opposite happens and debt becomes harder to pay off.

Due to the austerity measures installed in many Eurozone countries following the debt crisis, the Eurozone economy is barely expanding. Draghi fears that deflation could push the Eurozone economy back into recession. One of the reasons that Draghi had his hands tied was because he had already lowered interest rates to nearly 0%. Yet, he was failing in spurring inflation. That was where I stepped in to give Draghi some advice. On June 5th, Draghi listened to everything I had to say and held a press conference. The cameraman zoomed in on Draghi so I didn’t make the shot but I was sitting right next to Draghi during the press conference.

Firstly, I realized that European banks were parking their money at the ECB. Thus, I urged Draghi to set the ECB deposit rate to a negative figure. Negative deposit rates can encourage banks to take their money out of the ECB and perhaps lend it to consumers and companies because they would actually be losing money for depositing their cash at the ECB. This would spur growth and much needed inflation. Draghi followed my advice and lowered the deposit rate to -0.1%. He also lowered the headline inflation rate to 0.15% from 0.25%

Secondly, in the final hours of our meeting, we came with an idea to initiate a new financing program called Targeted Long Term Refinancing Operations (TLTRO)  where banks can borrow money from the ECB equivalent to as much as 7 percent of their outstanding loans to non-financial corporations and households. The loans will be given for 4 years. However, if these institutions don’t lend out the money they get from these loans, we will cut their maturities to two years.

Finally, I told Draghi to always have an ace of spades in his back pocket, in case the worst comes to worst. That ace of spades, would be outright bond purchases, just like Quantitative Easing in the US. We came to the conclusion that its better to wait and see how the Eurozone economy reacts to the policies we came up with that day, but letting the markets now that just like back in 2012, we would do whatever it takes to spur inflation in the Eurozone will help increase inflation expectations. Those are the unorthodox policies that Draghi touched on towards the end of his speech. Bond yields are already very low and QE in the United States has shown that bond purchases don’t necessarily spur inflation. However, the idea of bond purchases being a possibility will definitely play a role in protecting the Euro from appreciating.

After working for hours to come up with these policies, we finally called it a night and decided to go to Angela Merkel’s mansion in Berlin for a wild party. It was strictly BYOB. Apparently Merkel is tired of buying everyone drinks. All those bailouts in Southern Europe may be to blame. I can’t tell you what went down in that party. Lets just say that many world leaders wouldn’t want the pictures to leak to the press.

Popping champagne.
This is only the pregame.

Following Draghi’s press conference in June, Eurozone inflation remained stable at 0.5%. Draghi gave me a phone call last week and thanked me for his help. I told him that he owes me one and I gave him one final piece of advice.  I told him to publish the minutes from the ECB meetings, just like the way the FED does them. This would not only give the ECB some much needed transparency but would also increase the effect that his decisions have on market expectations.

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As you can see, my friend Draghi looks awfully cute when he is happy. I hope his happiness continues and that the Eurozone can get out of this deflationary trend soon. In the globalized world that we live in, our economies are extremely interconnected. Thus, the fate of one large economy can have an effect on all of our countries and all of our lives.

“If we do not resolve the euro crisis, we will all pay the price. And if we do resolve it, we will all benefit”
-Mario Draghi

 

 

 

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Angela Merkel Re-Elected in Germany

Germany is the fourth largest economy in the world and the largest economy in Europe. Because of its economic power and, *ahem* unlike certain countries in Europe, its strong trade surplus, Germany has become the de facto leader of the European Union. Thus, every time a bailout or an economic assistance package is negotiated with the fiscally troubled nations such as Greece, Portugal, or Cyprus, the European Union and the IMF must get Germany’s approval. After all, its the German taxpayers’ money that goes to those countries.

In addition to helping the heavily indebted nations of the Eurozone, the European Union is also in the process of creating a banking union. In a nutshell, the European Banking Union is a political vision for more integration with the goal of strengthening and extending the regulation of the banking sector across the EU. Because of Germany’s weight in the EU, they are a key nation in this process as well.

But, over the past 4-5 months, the EU has been in sleep mode as they were waiting for the results of the German election. Angela Merkel has been the Chancellor (the word those drunk Germans came up instead of President) of Germany since 2005. Here is the beautiful Mrs. Merkel here.

"I eat elections for breakfast"
“I eat elections for breakfast”

Merkel represents the Christian Democratic Party (CDU). They’re a center right party. Her main opponent in the election was Peer Steinbruck of the Social Democratic Party (SPD), which is a center left party. Here is the Steinbruck with a dashing haircut.

"I asked the magic 8-ball on my head if I would win, it said ask again later."
“I asked the magic 8-ball on my head if I would win, it said ask again later.”

Merkel had many factors playing in her favor leading to an election. Firstly, Germans trust her. She has been Chancellor since 2005 and has rightfully so earned the nickname, Mutti, or Mother in German. Of course lets not forget that Germany has been performing well economically when much of the rest of Europe has stagnated. The unemployment in Germany is much lower than the troubled countries of the Eurozone as evidenced by the graph below that was generated by Eurostat. As of May 2013, German unemployment is at 5.3%. That is a dream rate not just for countries in Europe but also for the United States.

german unemployment

On the growth side, German GDP has increased on average at 1-2% over the last couple of years. That is not that bad considering that a majority of Germany’s European export partners are in recession.

Finally, Merkel is one of the individuals credited with saving the Eurozone from the brink of destruction. Just two years ago, some people were beginning to even doubt if the European Union would survive the economic crisis it was in. The possibility of Greece exiting the Eurozone  was being discussed and many thought that if Greece exited, so too would other troubled nations. But, along with the support of the European Central Bank, Germany committed to do whatever it takes to maintain the Eurozone.

However, Merkel does have her critics. In Germany, there are those who are skeptical of bailing out country after country within the Eurozone by using German taxpayer money. In Europe, the name Merkel is frowned upon by some because of her support of continent-wide austerity (fancy word for budget tightening). To remedy the massive debt that countries such as Greece, Italy, Portugal, Ireland, Spain (PIIGS) have gotten themselves in, Merkel pushed for strong budget tightening. On paper this sounds good but it stagnates economies and effects the lives of ordinary people. Public workers get laid off, civil servant wages go down, and pension plans get reduced.

But the election came and went and Merkel’s CDU came on top, gaining 41.5% of the vote where as the SDP got only 25.7%. Germans trust Merkel and she is seen as a safe bet, especially in the economically murky times that they are in right now. Steinbruck and the SPD could not manage to run a campaign that would sway enough voters to turn on Merkel.

But that is not the end of our story. The math wizards among you might have seen that if you add the two percentages of votes, they equal to much less than 100%. What happened to the other 32.8% of the country? Well, similar to most European countries, Germany has a multi-party political system. In addition to the CDU and the SPD, there are several other prominent parties in Germany. Some of the other parties include the environmentalist Greens, the communist DIE LINKE, and the Pirate Party, which was founded through the internet. Though none of them managed to get more than 10% of the vote, since the CDU doesn’t have the majority of the vote by itself, it must form a coalition with another party. This can have a significant impact on the policies Merkel enacts as Chancellor. Prior to the election, the CDU was in coalition with the liberal Free Democrats (FDP). But the FDP managed to barely get about 2% of the vote. Right now it looks as if Merkel will either try to create a coalition with several of the smaller parties, or she will attempt to create a grand coalition with the SPD. That all depends on whether the SPD will accept Merkel’s offer and assist in the governing of country. Germans in general favor a grand coalition. But, history shows that the parties that enter a coalition with the CDU tend to do bad in the following elections. This could in effect cause votes in the next election to go away from the SPD to some extreme parties such as DIE LINKE or the Alternative for Europe Party, which is an anti Euro party.

Whether you like her or not, Merkel is queen of Germany for 4 more years. The rest of Europe seems to like it. European stocks rallied and the Euro gained in value against other currencies after her reelection was officially announced. Finally, the rest of Europe can stop twiddling their thumbs and get on with the much needed reforms to fix their economic and financial system. Right Obama?

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“The euro is our common fate, and Europe is our common future”
-Angela Merkel