E.U. CREDITORS MUST RECOGNIZE THEIR LOSSES / THE FINANCIAL TIMES MARKETS INSIGHT ( HIGHLY RECOMMENDED READING )

July 19, 2011 1:51 pm

EU creditors must recognise their losses

By Komal Sri-Kumar

Greece, despite €110bn in assistance from the EU and the International Monetary Fund last year, still cannot access private credit markets. Ireland and Portugal also needed bail-outs, and were still downgraded by rating agencies. Spain and even Italy have come into the investors’ crosshairs.

Why? The “bail-outs” provided little relief.

In every case, the EU and the IMF added to the countries’ debt and the austerity programs – salary cuts, higher public utility tariffs, and increased taxes – cut gross domestic product. The debt-to-GDP ratio, a key measure of country risk, rose. With Greece’s ratio forecast to go up from about 120 per cent in 2009 to 160 per cent by 2012, the authorities there have a snowflake’s chance in hell of ever gaining entry to private credit markets.

 

How did the erudite leaders from the core European countries and the legions of PhD economists at the IMF miss this basic fact? Simple.

In my opinion, the bail-outs were never intended to improve the debt-ridden countries’ economies, but to enable European leaders to pretend that no “credit event” had occurred. Credit impairment would have posed a serious threat to the stability of the banking system. Even though 10-year Irish paper is trading at less than 60 cents on the euro because of fears of a restructuring, creditor banks do not have to raise additional capital.

The French government’s proposal last month that banks exchange a portion of their short-dated Greek exposure for 30-year Greek obligations also stemmed from not wanting to recognise losses. The proposal lost its appeal only because Standard & Poor’s suggested it may amount to a “selective default”, since it involved exchanging securities on “less-favourable terms”. Even last week’s stress tests, which only nine European banks failed, seem designed to avoid transparency.

Another proposal, to use the bail-out funds to buy back Greek debt at a discount also got nowhere, since EU officials, rather than the market, would presumably decide the repurchase price and the maturities targeted.

The European Central Bank, and its president, Jean-Claude Trichet, are key players in the continuing crisis. After the May 2010 Greek rescue, Mr Trichet said the Bank had not discussed buying bonds from crisis countries, but he quickly reversed.

The ECB is believed to hold €45bn of Greek obligations, and a total of €75bn in peripheral country debt. Rather than resolve the crisis, these purchases discouraged investors who saw them as signs of stress.

Even more important, the ECB remains conflicted between its stated goal of maintaining low inflation rates, and its unstated objective of avoiding losses on its bond portfolio. The losses, if recognised, would require a recapitalisation of the ECB. This explains why the Bank has raised interest rates twice recently, even as it has bought peripheral country debt. A bit like plugging a leak in a reservoir even as torrential rains add to the overall water level.

Is there a way out of the European crisis? There is.

My experience with Latin American countries from the 1980s suggests two lessons. As long as the US Treasury and the IMF extended credit, thereby helping foreign banks maintain the pretence that there was no impairment, the countries’ debt ratios deteriorated, and they could not attract new investors. This is what the European nations are going through.

It took the introduction of a market mechanism in the form of the Brady Plan of 1989 to bring about a lasting improvement in Latin America’s debt service capacity. New investors were able to buy debt at discounted prices, and to use it to purchase state-owned companies. Growth resumed and most Latin American stock markets boomed during 1990-1993.

Europe can avoid Latin America’s “lost decade” only if creditors recognise losses promptly. Once this is done, new players – hedge funds, asset managers and pension funds – will extend loans reflective of the countries’ impaired status. Allowing investors to use debt as a currency to buy equity in troubled countries will also bring much-needed new capital.

Italy, which is no longer able to devalue its lira and gain competitiveness, can achieve the same goal by reducing its debt and the price of its assets. The measures should be sold to Italian workers pointing out that they would stimulate employment and – eventually – wages.

The good news for global investors is that European authorities will soon have to exit their sticking plaster policies since they are unsustainable. Market-pricing of the debt, sales of state-owned companies, and a further fall in stock market valuations will make for a bull market in distressed European debt, equity and real estate.

Long-term investors should patiently wait for these reforms to occur, but jump in with both feet when credible debt restructuring efforts are announced.

Komal Sri-Kumar is chief global strategist at Trust Company of the West (TCW)

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Copyright The Financial Times Limited 2011