More on Credit Risk and Currencies

Last week, I tried (albeit unsuccessfully, in my view) to explore the relationship between market based indicators of credit risk like CDS spreads and currencies. The data didn’t give a lot of evidence to the linkage, but frankly, I can’t let it go because it makes too much damn sense to me. Dubai brought this issue back into focus, but that was really a contrast between their GSEs and our GSEs.

But lo and behold, the issues being discussed about PIIGS just won’t go away. Der Spiegel shows you what the buzz is over in Germany this week:

As economic indicators have improved, concern about the financial crisis has abated. But the next big problem could be approaching. Greece’s public deficit is skyrocketing and the country may become insolvent. The effect on Europe’s common currency could be dire.

Sovereigns have some options open to them that others don’t: they can raise taxes, they can cut spending, they can get assistance from the World Bank and IMF, or they can devalue their currency. But since Greece doesn’t have control of its own currency and monetary policy, they don’t have the last option like Thailand did. Thailand actually did end up seeing their currency devalued during the Asian debt crisis, in addition to the other fiscal measures to balance the budget.

But that one limitation is huge. A country without the ability to govern its own monetary policy will always be held captive to the monetary policies of others, regardless of what that country faces from a macroeconomic perspective.

So they can default, they can receive aid from Brussels, or they can make the budget cuts they need to make. None of these are particularly rosy.

On the prospects of a Greek default:

A default of a euro-group country doesn’t worry the monetary policy hawks at the Bundesbank, Germany’s central bank. “So what if Greece stops paying its debts?” one of the executive board members asked at a recent banquet in Frankfurt. “The euro is strong enough to take it.” The real threat, he says, is if Brussels comes to the Greeks’ aid. “Then the currency union will turn into an inflation union.”

So the Germans are at least projecting confidence in the Euro in the face of a potential default. The euro might be able to handle Greece defaulting, but one default could start a domino effect of country defaults.

Either way, the issues are crystal clear to everyone: bailouts at the expense of others or defaulting on debt. Again, the article sums these up rather crisply.

On bailing out the Greeks:

The lack of concern over budget discipline in countries like Spain, Italy and Ireland would spread like wildfire across the entire continent. The message would be clear: Why save, if others will eventually foot the bill?

On letting the Greeks default:

On the other hand, if Brussels left the Greeks to their own devices, the consequences would also be dire. Confidence in the euro would be shattered, and the union would face a crucial test. What good is a common currency, many would ask, if some of the member states pay their debts while others do not?

Either way, it points to a devaluation of the Euro. And since the Greeks have €25Bn that they need to refi/roll next year, the Greeks represent a serious litmus test for the European Union, and their debt holders:

A national bankruptcy in Greece would have a serious impact on Germany, where many banks have invested heavily in the high-yield Greek treasury bonds — after borrowing the money to buy the bonds from the European Central Bank (ECB) or other central banks at rates of 1-2 percent. Making money doesn’t get much easier — as long as the Greeks remain solvent.

Oops…

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Filed under finance, government, macro, Markets, Way Forward

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