Politics of Default: Roadmap to
Debunk the Dollar
Axel Merk, Portfolio
Manager, Merk Funds July 7, 2011 www.merkfunds.com/merk-perspective/insights/2011-07-07.html We were one of few who defended the euro when
many pundits predicted parity to the U.S. dollar in the spring of 2010, when
Greece’s issues first came to the fore. Since then, Old Europe’s currency has
had a dramatic comeback, although not without significant jitters along the
way. A roadmap is playing out that may lead the euro to debunk the dollar.
Not convinced? Let’s look at what is and what isn’t working on both sides of
the Atlantic, and how dynamics may play out.
If one thing has been working in Europe, it’s the
“dialogue” between the bond market and policy makers. Not too long ago, the types
of reforms being implemented now would have been unthinkable. What’s more, in
many cases, reform is being implemented by weak or minority governments.
Reforms may not be implemented at the speed or as thoroughly as promised; as
long as the bond market keeps up the pressure, however, an incentive is
provided to continue to engage in reform, which makes it each individual
country’s responsibility to sort out its problems, and thus influence the
speed at which their cost of borrowing is reduced. Except, of course, when a country receives a
bailout in which the cost of borrowing is reduced. Note, though, that any
country tapping a bailout facility may be shunned from the capital markets
for an extended period. Portugal had resisted asking for help, because no
other country that previously had was really much better off – at least when
measured by the cost of borrowing imposed by private lenders. Private lenders
won’t give countries a free pass unless economies are returned to a
sustainable path. There are frequent calls for a fiscal union
within the Eurozone; such a fiscal union would also
impose some budget constraints on member countries, but likely lack the
drama. However, odds are also high that it would be far easier to transfer
money to weaker members, thus removing an important incentive for such
members to engage in reform. From a currency standpoint, such a development
would be a negative for the euro. As it stands, it is simply more difficult
to spend money in the Eurozone than in the U.S. But
doesn’t that lead to less economic growth? To answer this question, consider
that Japan has had lousy economic growth for two decades, yet a strong
currency. Japan has historically financed its deficits domestically; as a
result, in our assessment, the yen does not need economic growth to prosper.
That’s very different from the U.S., where the U.S. current account deficit requires foreigners to
invest billions, just to keep the dollar from falling: foreign capital may be
more easily attracted when there’s a prospect of growth, making the U.S.
dollar more sensitive to changes in perception of future economic growth. The
Eurozone’s current account is roughly in balance;
as a result, while economic growth plays a role in determining the value of
the euro, it’s not as important a factor as it is in determining the value of
the U.S. dollar. Separate is the question whether structural
reform does indeed lead to less economic growth. Structural reform is a way
to get rid of the excesses built up during boom years. In the U.S., possibly
the greatest impediment to economic growth is that structural reform is not
taking place: consumers are subsidized to stay in their homes rather than
encouraged to downsize to homes they can afford. The reason? It might be
political suicide to promote “downsizing”, as it implies foreclosures and
bankruptcies. However, getting rid of the excesses may be exactly what is
required to build a sound foundation for sustainable growth. But what if such “sustainable growth” is simply
not in the cards: few believe that Greece will ever be on a sound footing
again. Any country may default on its debt; trouble is that it may be
difficult to obtain a loan at palatable terms upon default. Differently said,
for default to be a viable option, a country must be willing to eliminate its
primary deficit overnight (the primary deficit is a country’s budget deficit
before interest payments); once the primary deficit is low or eliminated, it
may be in Greece’s interest to take the pain associated with a default to
reduce its debt burden. The reason why a country’s default is typically
preceded by years of painful choices is because that’s exactly what’s
necessary: make the tough structural adjustments to prepare for default. A
default now is not in Greece’s interest, especially not if cheap loans are
lined up by the IMF and Eurozone, as important
reforms have not yet been tackled. Such reforms are rarely implemented as thoroughly
as planned (after all, there is a reason why the country got into trouble in
the first place), but substantial progress is typically made. Greece is in a
very different situation now than it was just a few days ago: the country has
secured financing until the end of 2013. This allows Greece two years to
either prepare for default or have a credible turnaround strategy in place.
Specifically, now is the time for financial institutions, including Greek
banks to be recapitalized to stomach a Greek default. As far as reform in Greece is concerned, there
will always be political differences as to what the right recipe is to put a
country on a sound footing. In times of crisis, thinking outside of the box,
however, might be prudent. Greece’s opposition leader Samaras has a reform
plan that includes, amongst others, the elimination of the requirement of
proving the origin of money when purchasing a house. This idea may help get
money back into Greece that has been fleeing the country, while lowering
unemployment by fostering the labor-intensive construction sector.
Importantly, elections in Greece should take place before the regularly
scheduled date in 2013 to allow negotiations to take place on an orderly
restructuring in late 2013, should that be necessary. While some have
shrugged off opposition leaders Samaras’ call for tax cuts as unrealistic, he
favors dismantling government bureaucracy, an issue the current Papandreou
government has not been forceful enough on. Should there be elections, it’s
likely that Papandreou’s government would lose its absolute majority in
parliament; whether Samaras could gain enough votes to govern without a
coalition partner is questionable. A strong vote for his party could end up
in a coalition to engage in real reforms that go beyond austerity measures,
but implement moderate, but urgently needed pro-growth measures. While a new
government elected in 2013 might be effective, it may be more helpful to have
an established government in place ahead of any 2013 negotiations. Greece is relevant for the rest of the Eurozone to the extent that Greek debt is held by
financial institutions. As such, it is paramount that the time until 2013 is
used to finally clean up financial institutions in earnest, at risk of
significant shareholder dilution. As this analysis is written, Nigeria warned
it may nationalize its banks because financial institutions there, too, are
dragging their feet. Is Nigeria more willing to get its house in order than
France or Germany? One lesson from the financial crisis is that
rating agencies don’t want to be caught out again, downgrading any one
institution or country too late; Portugal being the latest country to hit the
news for yet another downgrade. There’s a fair concern that should countries
bail out their banks, it would drag the banks down themselves. But the issues
must be tackled more assertively, so that the markets don’t take care of them
on behalf of policy makers. It appears to us that this might be taking place
as policy makers are now considering more serious stress tests, amongst
others. Note, though, that one of the biggest contagion
fears with regard to a European banking crisis is to U.S. money market funds.
As we have discussed (see our June 22 analysis “Euro safer than U.S. dollar?”),
many U.S. money market funds have dramatic exposure to European banks through
U.S. dollar denominated commercial paper issued by them. As of this writing,
three month U.S. Treasury bills just yielded a negative annualized 0.01%, a
clear sign that there may be panic buying, quite
possibly as a result of institutional investors fleeing money market funds
(another interpretation is that investors are afraid of an upcoming shortage
of Treasuries as the debt ceiling is reached). Finally, we have learned that central bankers are
bad poker players. Be that the Federal Reserve (Fed) that may provide support
to U.S. money markets or the European Central Bank (ECB) that is bending over
backwards to find ways of accepting Greek debt as collateral. As a result, we
come back to what we indicated earlier: the bond market imposes real reform
in the Eurozone; and it’s more difficult to spend
money in the Eurozone. Conversely, in the U.S., the
bond market continues to give the government a free pass; while we believe
the debt ceiling debate is mostly a game of chicken, we don’t expect true
structural reform that would lead to manageable entitlements over the
long-run. If and when the bond market in the U.S. imposes real reform, the
U.S. dollar might be far more vulnerable than the euro given the U.S. current
account deficit. Please
join us for a Webinar on Thursday, July 21, to discuss the future of the
U.S. dollar in light of the looming debt ceiling in the U.S., crises in
peripheral Eurozone countries and global
inflationary pressures. You may also want to sign up to our newsletter to be in the loop as this
discussion evolves. We manage the Merk Absolute
Return Currency Fund, the Merk Asian Currency Fund,
and the Merk Hard Currency Fund; transparent
no-load currency mutual funds that do not typically employ leverage. To learn
more about the Funds, please visit www.merkfunds.com. Manager of the Merk
Hard, Asian and Absolute Currency Funds, www.merkfunds.com Axel Merk, President
& CIO of Merk Investments, LLC, is an expert on
hard money, macro trends and international investing. He is considered an
authority on currencies. The Merk Hard Currency Fund
(MERKX) seeks to profit from a rise in hard currencies versus the U.S.
dollar. Hard currencies are currencies backed by sound monetary policy; sound
monetary policy focuses on price stability. The Merk Asian Currency Fund
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dollar. The Fund typically invests in a basket of Asian currencies that may
include, but are not limited to, the currencies of China, Hong Kong, Japan,
India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan
and Thailand. The Merk Absolute Return Currency
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currencies. The Fund is a pure-play on currencies, aiming to profit
regardless of the direction of the U.S. dollar or traditional asset classes. The Funds may be appropriate for you if you are
pursuing a long-term goal with a currency component to your portfolio; are
willing to tolerate the risks associated with investments in foreign
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