Download IMPACT OF THE EURO DEBT CRISIS ON

European Inter American Finance LLC
(The Eurinam Group)
11900 Biscayne Boulevard, Suite 612
Miami, Florida 33181
(305) 891-8665 FAX (305) 891-3686 (Miami)
(212) 759-0010 FAX (212) 759-1279 (New York)
E-mail: [email protected]
PRESENTATION AT EMTA FORUM
MIAMI, JANUARY 17, 2012
“IMPACT OF THE EURO DEBT CRISIS ON
EMERGING MARKET DEBT TRADING IN 2012”
1) Europe
After last week’s breakdown of Greek restructuring negotiations with private
creditors, I ask myself, is the Southern European debt crisis leading us down
the path to a global financial disaster, as there is just too much debt, as I
often said in the 80’s, following the Latin American debt collapse.
Whether the Eurozone will remain intact is questionable after Friday’s S&P
sovereign downgrades and breakdown of debt restructuring talks with
Greece and will depend on whether the present policy of sharp curtailment
of budget deficits without growth is workable. In my opinion, not for long.
The critical date is coming up when by March 20th Greece will have to
redeem 14.4 billion Euro bonds and official creditors must have approved a
second 130 billion Euro bailout package and private creditors signed off on a
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50 to 60% haircut on 206 billion Euros of privately held bonds, as a
condition for an estimated 89 billion Euro first quarter disbursement by the
so-called Troika of lenders, part of which will be used to implement the 30
billion Euros of upfront cash to private creditors and about 40 billion Euros
to recapitalize Greek banks as a part of the restructuring agreement. If this
does not happen, the Eurozone crisis will deteriorate sharply. To make the
numbers work and achieve a target debt to GDP ratio of 120% by the year
2020, 100% of private creditor held debt of 200 billion Euros will have to
participate in the restructuring. However, only 60% of this amount is held
by banks and the balance by hedge funds and private investors who oppose
the deal and prefer an involuntary agreement which would trigger off the
CDS’s and permit them to collect on their hedges significantly more than
they would recover under the restructuring agreement.
The Greek government will try to insert a retroactive collective action clause
(CAC) in the agreement this week to require all creditors to agree if a
majority of creditors agree, to avoid the holdout conflict. Failure to agree on
a voluntary default will result in a disorderly bankruptcy, contagion and
potential collapse of the Euro. Note Greece’s total debt is now at 1.1 trillion
dollars including sovereign, bank and municipal debt and 90 billion dollars
in derivative contracts.
This week will be crucial with the Troika in Athens and talks resuming. The
interest rate of 4% and the term of securities ranging between 20 to 30 years
are other issues which will require a sweetener. Greece is trying to force the
interest rate below 4%.
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Whatever happens, I expect the situation in the Eurozone to get worse before
it gets better. The latest S&P triple A ratings downgrades of France, Austria
and yesterday the EFSF, creates another dilemma as to whether the EFSF
440 billion Euro fund could become short of credit guarantee funds if Fitch
and Moody’s follow S&P. Introduction of the ESM, which relies on paid in
capital for its rating and Europe’s sovereigns may be accelerated. The ECB
will continue to blow up its balance sheet a la the U.S. Fed in an effort to
contain systemic pressures on banks. But the Eurozone economies will
continue to gradually sink into recession impacting on commodity prices and
other regions of the world including the U.S. and China. Sovereign bond
prices around the world will suffer from accelerating debt. Corporates will
fare better than sovereigns, particularly in the Emerging Markets.
For most debtors, the current debt trend is unsustainable unless sovereigns
can grow themselves out of the problem. For example, the Italian economy
expanded at an average of .03% annually during the past 10 years and less
during early months of 2011, while government debt continued to grow
pushing up bond prices to critical levels. Italy’s debt is unsustainable unless
borrowing costs are reversed and the economy begins to expand, difficult
under present strict budget restraints. Gross Italian sovereign debt of 2.5
trillion Euros held by banks and investors exceeds the combined debt of
Greece, Ireland and Portugal who have already undergone initial bailouts.
The latest S&P sovereign downgrades compound the problem even more, as
cost of new financing will become even more expensive to refinance the
large amounts of debt coming due this year. Italy’s two-level downgrade
will be especially painful.
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Whether the Eurozone will remain in its present form is questionable. What
we do know, is that following the Greek haircut more countries will undergo
debt restructuring and a serious decline in bond prices. The most vulnerable
countries are Portugal, Ireland, Italy and Spain.
How restrictive will debt restructuring agreements be and how much of
a haircut will creditors have to take?
The amount of haircut will differ country to country. In the case of Greece,
no less than 60% will be a viable solution. Governing law will have to be
changed from local to U.K. or Swiss law. For example, in Greece 90% of
the total loans held by investors is governed by Greek law, which will not be
acceptable to creditors. Terms of the new bonds will have to include
collective action clauses (CAC) so that acceptance by a prescribed
percentage of holders of the new payment terms binds all other holders so
that no holdouts “a la Argentina” are permitted to disrupt future capital
market fund raising when the country is back on its feet. Creditors will have
to accept a “reasonable” interest rate, probably averaging 4%, not too
burdensome to debtors, with a provision to increase when GDP exceeds an
agreed level. Compensation to creditors should be bolstered by GDP
warrants and similar bonuses. Maturity will likely be 30 years.
Are we on the verge of a European lost decade a la Latin America of the
80’s?
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Very definitely, without major international support and an orderly reduction
of debt.
What impact will the Euro debt crisis have on Emerging Markets?
The Eurozone region accounts for almost a quarter of global consumption of
oil and nickel and about a sixth of other metals, such as copper. Demand has
dropped sharply in recent months. Emerging Market countries, particularly
commodity producers, are extremely vulnerable. Brazil, Mexico, Peru,
Ecuador and Venezuelan bond spreads will widen and currencies will
weaken against the dollar. At a time when Chinese purchases are slowing,
commodity prices will be under pressure and impact trade balances.
Who would be the first to pull out of the Eurozone and what will the
consequences be?
Greece is the most likely initial candidate in the event of default and the
consequences will shake the financial world. Several of the smaller
countries will follow quickly, but Italy is a country to watch, as it would
impact on the entire Eurozone.
2) What is the risk of financial contagion and what danger do U.S. banks
face?
The global interconnection of financial institutions through the Euro loan
market makes all large banks vulnerable in the event of a Eurozone breakup.
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A major question in my mind is who are the banks who have written the
CDS’s in the event of default and exercise of the CDS. This could be
catastrophic for those involved. The most likely institutional sellers are
European rather than U.S.
What needs to be done:
In the short run, kicking the can down the road until the ECB can adopt
viable measures with international support is urgent. Without creation of a
fiscal union, the Euro cannot survive. More “bazookas”, following the
December massive loans to banks to liquify the Euro market in the
meantime is a must. More interest rate cuts will have to be made by the
ECB to reduce the rate below 1%. This will weaken the Euro versus the
dollar and improve Eurozone exports.
What role should privatization play?
In most Southern European countries, sovereigns own a significant amount
of companies and properties. An effective privatization program must be
organized, which should include, where appropriate, “debt at a discount”
combined with cash in order to attract investors. Government owned
utilities will be a seller of ownership interest in third countries wherever
possible, such as the Greek Hellenic Telecom selling back its 20% stake in
Serbian Telecom for 380 million Euros.
What will the role of the IMF be?
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It is important that the IMF be very much involved. The U.S., the IMF’s
largest shareholder today, will be against an IMF bailout unless the situation
becomes critical. Then anything is possible, including participation by other
countries including China and possibly Brazil in some way. The present
scheme is for the ECB to lend funds to the IMF and the IMF re-lend to Euro
countries, as the ECB is not permitted to lend directly to member sovereigns.
The IMF will have to do a better job than it has done with Ireland, Greece
and Portugal, who have had rescue packages but remain under critical
condition.
3) United States and China
The Southern European debt crisis will result in a slowdown of U.S. growth
in the next six months but I do not expect any serious recession. The rising
U.S. dollar rate will also impair the trade balance and reduce U.S. exports.
Interest rates will stay low, as the Fed is likely to respond with another
quantitative easing. U.S. equity markets will continue to be impacted by
event news in Europe and markets will be very volatile.
China will also be affected by a declining growth rate in 2012 but I don’t
believe there will be a hard landing. The Chinese government is already
taking measures to stabilize growth and ease monetary conditions.
4) Corporate Bonds and best fixed income investments for 2012
The Euro crisis will cause a sharp world economic slowdown if present
trends do not correct. Deflation rather than inflation will be the major
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dilemma and commodity prices will decline. Governments will resort to the
printing press to repress stagnation.
I would favor Emerging Market corporates selectively rather than
sovereigns, particularly Mexico, Chile Brazil and Colombia. Weakest will
be Argentina and Venezuela. Trading markets will be volatile and volume
scarcely above 2011 due to the investor fear factor over Euro headline news
through most of the year. The impact of bank deleveraging in major money
centers will restrict investment. The default risk for corporates, however,
does concern me in this atmosphere, as sales in the Eurozone will slow.
5) Outlook for investment in Emerging Markets
2012 will be another year of risk on-risk off and extreme volatility due to
Euro area problems. Investors will have to watch how yield spreads develop
across different regions.
Headline risk scary:
a. Euro breakdown;
b. Iran war;
c. Middle East oil crisis;
d. Arab Spring political tensions;
e. U.S. elections.
Is it time to buy Southern European distressed debt?
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Not yet. Italy and a number of other countries in Southern Europe are
unsustainable situations at present bond rates. It is a train wreck waiting to
happen without a major “bazooka”, which the ECB alone may not be able to
handle at this time. The time to jump in will likely be sometime in the
second semester, assuming present trends continue.
6) Main Surprises
China helps heal Euro breakdown.
IMF contributes more help.
In conclusion, prospects in Southern Europe certainly look bleak, “as there is
just too much debt”, but as we also said in the 80’s “there is life after debt”.
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