Why the rescue of troubled Euro zone countries will be difficult

The markets over the last few days have been jittery because of concerns regarding Ireland and whether that country will be given a free lunch and bailed out by the Euro zone rescue fund. The key aspect to consider however is whether a bailout is the best option or lenders should be forced to take haircuts and the bailout should be dependant on that.

Because of the lack of credibility of the austerity measures/recovery of troubled countries and the lack of faith in their ability to pay back the money that they are borrowing the yields on bonds of these countries have shot up over the last two months. Ireland that used to borrow at around 4.5% at the beginning of the year now has to borrow at 9%. Similarly Portugal that had borrowing costs at 3.5% now needs to pay around 7%. The major factor here is not just the ability to borrow but also the ability to service the debt as given the debt to GDP ratios of these countries and the fact that growth is not going to pick up anytime soon due to budget cuts and lack of a monetary stimulus it is going to be a difficult task. Fast growing economies with high GDP growth can sustain higher deficits and borrowing at higher rates as the growth takes care of the high interest payouts. However for these countries it will become virtually impossible to service the debts if not now, maybe a year later.

Let’s understand this with an example. The overall debt burden of Ireland which comprises assets of the bad bank that they have set up is estimated to be around 130% of GDP. Now if the borrowing costs were 4% then the interest payouts in a year would have been 5.2% of GDP, however with borrowing cost of 9% this goes up to 11.7% of GDP which is an increase of 6.5% over the earlier figure. As such just interest payments increase per year will increase the Budget Deficit by 6.5%. Given the fact that recovery is going to be slow the increase in revenues of the government will also be very slow and this will lead ultimately to a vicious cycle that will need a drastic restructuring of debt sometime in the future.

The key in my view is to bite the bullet and bring about a sustainable recovery and payback plan for these countries, which will obviously involve lenders taking haircuts and the reduction in the overall debt burden of these countries. The case here is very different from that of the US and UK where the bonds of these countries were perceived to be save havens and as such despite the financial crisis and huge ballooning of deficits the bond yields did not move up and infact moved down. Bond buying by the central bankers in these countries also helped. As such bailouts are more likely to work in these countries as the borrowing costs of the Governments have not moved up despite increasing deficits.

However the key point in the US FEDs quantitative easing policies is that eventually what happens to the bonds that the FED is buying. In real terms it is a phenomenon that is nothing but shifting the burden from one part of the establishment to the other i.e. the US Government does not increase its deficit and the FED balance sheet keeps on expanding. In reality the deficit should be measured by combining the expansion of the FEDs balance sheet as well as the Federal Governments deficit. The withdrawal from the QE programmes is likely to be a very difficult task that could cause financial market disruptions as and when it happens.

On China

My view on the Chinese currency movements always was that it is domestic pressures rather than external that will force it to act on the currency. Eventually not letting the currency appreciate was bound to feed into the inflationary pressures in the country given the strong growth in consumption over the last 3-4 years. Given the way commodities have rallied and the fact that food related inflation continues to be high the Chinese will now not only need to tighten monetary policy but also let the Yuan appreciate faster. This is something that we should see over the next few months. Hopefully this will also reduce inflationary pressures in other emerging economies.

On Markets

Markets have been increasingly volatile over the last few days mainly due to issues related to Euro zone. Technically the US Dollar seems to be bracing up for a sharp up move which could cause a sell off in risky assets. The key is to see whether the USD move actually fructifies as there have been false signals in the past too. However given the fact that QE2 did not result in a further sell off in the USD given the increasingly crowded trade on USD shorts the probability of a bounce if not a trend reversal is the most likely scenario.

Results season has gone off well and most companies have done well. However one negative that I have seen across the board has been an increase in inventories and a deterioration of the working capital cycle. Whether this is due to stocking for strong future growth or indication of a short term slowdown needs to be seen. However this can increase interest cost as short term CP rates have moved up sharply by nearly 200 basis points and liquidity in the system continues to be tight. The industrial production data was extremely disappointing, however difficult to believe in light of the results reported by capital goods companies.

Overall I would continue to remain cautious on the markets in the near term and would wait for any significant correction in the markets to increase exposure. A 10% correction from the current levels could provide a good entry point for investors on the sidelines.