Euro zone deal overlooks a major threat: lousy growth
Stricter budget discipline in the 17 countries that use the euro is all well and good, but investors fear it won't provide what the euro zone needs most of all: More economic growth.
Money managers say that means Friday's stock market rally and euro gains could be short-lived, particularly if credit ratings agencies decide to strip any of Europe's top-rated countries of their AAA status.
"The fundamental problem in the most troubled European countries is the debt burden is growing at a faster rate than their economies are," said Michael Cheah, who manages a $1 billion fixed income fund at SunAmerica Asset Management in Jersey City, New Jersey. "That's been the problem for a long time. Yet the only solution we get is more discipline, more austerity."
All 17 euro zone countries agreed Friday to draft a new treaty that would allow Brussels to enforce tougher fiscal discipline, making it harder for governments to wriggle out of their highly unpopular and painful austerity programs.
Investors, though, fear this will make it nearly impossible for weak countries such as Greece, Spain, Italy and others to grow quickly, adding to already large debt burdens.
Italy's government, for instance, presented a 30 billion euro ($40 billion) package of spending cuts and tax hikes this week even though the economy is forecast to shrink by 0.5 percent this year and post zero growth in 2013.
If markets lose confidence in the countries' economic viability, they will likely stop lending them money, driving borrowing costs back to unsustainable levels and reviving fears that some countries will be forced to leave the euro zone altogether.
The plan "is not going to restore confidence in Italian and Spanish bond markets," said Nicholas Spiro, director of Spiro Sovereign Strategy, a London-based consultancy that specializes in sovereign risk.
Italy's 10-year government bond yield rose to 6.85 percent on Friday, capping a roughly 55-basis-point weekly rise and pushing it back toward the dreaded 7 percent level at which markets fear Rome won't be able to roll over maturing debt.
Spiro called the Italian 10-year yield "the best barometer for market stress in the euro zone" and said its rise in spite of the treaty agreement was "cause for serious concern."
Many economists fear the euro zone is on the verge of or already in recession, and the European Central Bank this week tempered its growth projections for 2012.
Goldman Sachs, in a note to clients published late on Thursday, suggested that investors short German equities through the benchmark DAX index.
"The European summit seems focused on a set of future priorities for increased fiscal risk-sharing and the outlining of some of the needed elements of a new fiscal arrangement, but looks to have little to say about alleviating proximate stresses in Greece and Italy and the European banking system more generally," Goldman said.
Imminent Disaster Postponed?
While not a panacea, Friday's agreement did manage to alleviate fears of an imminent euro zone demise, some analysts said. That is partly because it allows the bloc to provide up to 200 billion euros to the International Monetary Fund that could be used to help backstop troubled countries or banks.
Greg Anderson, a G10 currency strategist at Citigroup, said that is also why short-dated Italian and Spanish yields retreated even as yields at the back end of the curve remained elevated.
"It doesn't inspire you to go out and buy long-dated paper, but if you had a short on and you expected this whole thing to blow up by year end, well, you'd better take that off, because it isn't going to happen."
He said the euro, last trading around $1.3360, could even push up toward $1.35-$1.36 by year end as crowded bets against the currency are reduced.
"But I would still bet you that when the market levers up again and puts on its favorite trades in January, the euro will be the funding currency of choice," Anderson said.
It will be another story if rating agencies downgrade France, Germany or other AAA-rated euro zone states, a scenario Anderson said could shave two cents off the euro-dollar rate.
Standard & Poor's warned this week it could cut the ratings of 15 euro zone countries if European leaders failed to make bold steps toward solving the crisis.
There are another reasons to worry, too.
SunAmerica's Cheah said the ECB's single-minded effort to fight inflation and its reluctance to ease pressure on countries by buying more of their sovereign debt was keeping the euro too strong, making it even harder for Spain, Italy, Portugal and others to regain competitiveness and boost economic growth.
While the Federal Reserve fired up its printing press and poured more than $2 trillion into the financial system in recent years, the ECB has said it would buy euro zone bonds in only limited amounts.
But Douglas Borthwick, managing director at Faros Trading, a currency execution and advisory firm that counts hedge funds, corporations, real money managers and central banks among its clients, said IMF loans and a 500 billion euro emergency fund due to come on line next summer would help fill the gap.
He said ECB restraint and market pressure are crucial to getting recalcitrant euro zone countries to embrace sounder fiscal policies, something the United States, with a budget deficit at nearly 10 percent of output, has not done.
"It was only through the market forcing Europe to get its house in order that they did that. The United States has not gone through that yet," he said. "There has to be a reckoning at some point."
[Source: By Steven C. Johnson, Reuters, New York, 09Dec11]
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