Tuesday, February 9, 2010

Will EU Accept Greece's Trojan Horse of Debt?

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

International markets are looking for resolution to the debt crisis in Greece. European Union leaders have a summit meeting on February 11th and either a debt restructuring or a bailout of some type is on the wish list of traders. Whatever happens however will only be at best a temporary solution that will delay the day of reckoning for the global financial system. In the short-term, it will not undo the damage done to the euro nor to the stocks and commodities that have been impacted by the currencies current drop.

The problem in Greece is neither new nor exceptional for the EU. The conditions of the currency union in the euro zone have been violated from day one. The Maastricht Treaty set a limit for budget deficits of 3% of GDP and a 60% limit for the debt to GDP ratio of participating countries. The euro was launched in 1999 and replaced individual country currencies in 2002. Germany itself, the economic powerhouse of Europe, had a budget deficit of at least 3.7% between 2002 and 2004. France also violated the treaty conditions within the first three years, as did Portugal. The Netherlands did so in 2003. Initially Greece appeared to be in compliance, but was later accused of manipulating its statistics (a historical commonplace for fiscally irresponsible governments) and later admitted that its budget deficit averaged 4.3% between 2000 and 2004.

The euro currency union actually helped countries reduce their budget deficits by lowering their borrowing costs. When the debt to GDP ratio becomes large, reducing interest payments can reduce the budget deficit considerably. This phenomenon benefited Italy tremendously. Interest rates on Italian government bonds fell from around 12% in 1994 to 4% in 2004. It also improved the situation in Belgium. Belgium's debt to GDP ratio was 134% in 1993, but only 90% in 2008. It has never gotten anywhere close to the 60% limit. Italy's debt to GDP ratio in 2008 was 106% and is growing rapidly. It will not be long before it reaches Greece's 120% level. Yet, the market is focused more on Portugal with an 85% ratio - equivalent to the official numbers in the United States (the actual numbers are similar to Greece's) and Spain which has only a 66% debt to GDP ratio.

The EU rules don't have any provisions for bailing out one of the members of the currency union. Such legal niceties though can easily be ignored during a crisis. The EU executive committee has furthermore previously maintained that no bailout of Greece will be needed. Mid-day on February 9th however, news was released stating that the euro zone countries have decided in principle to aid the debt-stricken country. Reports indicated that the EU authorities were considering a range of possible actions, but no specifics were given. The euro of course rallied strongly on the news.

The euro has traded down from a high around 1.51 to the U.S. dollar in late November to the 1.36 level on February 5th. It is trading well below its 200-day moving average at the 143 level. The 50-day moving average, also at the 143 level, is about to cross the 200-day and trade below it, giving a classic bear trading signal.  The euro will not be able to recover from this technical damage overnight. Nevertheless, sharp counter rallies are inevitable since short positions on the euro have reached a record. This will create conditions for a nice longer-term rally in the future, but a period of volatility is more likely first. Commodities, particularly the precious metals, and U.S. stocks tend to trade with the euro, so investors should expect them to follow this pattern as well.

Disclosure: No Positions

NEXT: Economists and Governments Pave the Way for Global Inflation

Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

No comments: