European Debt: Another Domino Falls
TCW Investment Management
By Komal Sri-Kumar
March 24, 2011
The entire opposition in the Portuguese parliament voted to reject yet another set of austerity measures proposed by the government, and Prime Minister Jose Socrates promptly tendered his resignation yesterday. Both developments had been widely anticipated. They come at an awkward time for the European Union which begins a two-day summit today in Brussels intended to provide a resolution to the long-simmering debt crisis. Even though Mr. Socrates is expected to attend the sessions as a caretaker Prime Minister, he will not have the authority to propose specific austerity measures, and the summit is likely to result in more muddling through in the region’s debt crisis. A bailout package for the country in the neighborhood of €70 billion is anticipated, probably following fresh elections and the inauguration of a new government by early summer. The financial aid is urgently needed since Portugal cannot afford to pay the high rates demanded by the capital markets. Today, 10-year Portuguese paper is yielding 7.44%, and 5-year paper 7.92%. In the past, Portuguese authorities have said that anything more than 7% is not a sustainable cost.
Portugal Follows a Pattern Set by Greece and Ireland
Portugal will be the third European country to be bailed out in recent months following Greece (May 2010) and Ireland (November 2010). It also follows a pattern of individual governments and the EU repeatedly asserting that no bailout is necessary, that the high bond yields and rating downgrades are unjustified, and that “speculators” are largely to blame for Europe’s problems.
I conclude otherwise. With a faulty structure – a common currency but no means of fiscal coordination or transfers – the present setup is crying for change. While Portugal would be relatively easy to bail out – €70 billion is a manageable sum for the IMF and the EU to raise – the market attention
will now turn to Spain. With a GDP approximately twice that of Greece, Ireland and Portugal combined, Spain is just too big to bail out. It is also too big to fail, being the fourth largest Eurozone economy after Germany, France and Italy.
Debt Restructuring, Weaker Euro in Prospect
To repeat my often-stated belief, the band aid solutions the EU has applied to Greece and Ireland, and will soon apply to Portugal, are just not sustainable in the context of free capital markets and structural weaknesses of the Eurozone. In Latin America, the U.S. Treasury and the IMF were part of a group suggesting between 1982 and 1989 that the debt crisis was merely a liquidity-driven one, and that piling on additional debt, accompanied by tougher and tougher austerity conditions, would resolve the debt problem. Europe may not have the luxury of seven years in the presence of more active global financial markets. Sooner rather than later, European debt will need to be restructured with “haircuts” for senior lenders.
Finally, the euro at $1.42 also appears to be unsustainable. Fed Chairman Ben Bernanke’s insistence on continuing QE2, combined with ECB President Jean-Claude Trichet’s indication that the benchmark interest rate will rise early in April, are both factors in the euro’s strength. But in the race to the bottom in the two currency regions, I think the burden of European debt will prove overwhelming, and that the euro will move toward the $1.25 level.
(c) TCW Investment Mangement
