Tempted by a eurobond honey trap
In wake of disappointment in Spain's rescue, pressure is building for a eurobonds solution. But as Charles Gave warns, this would aggravate the problems of almost every eurozone player.
Proponents, such as French president Franois Hollande, argue that eurobonds – debt jointly guaranteed by all eurozone countries – would benefit countries such as Spain and Italy, because they would be able to borrow at much lower rates.
But in an excellent article, GaveKal’s Charles Gave argues that eurobonds will make the situation even more unmanageable because they will merely paper over the debt trap that is ensnaring an increasing number of European countries. He argues that the only way out for struggling eurozone countries is through "a growth boosting improvement in competitiveness, which cannot be done under a monetary union”.
Gave uses the example of Italy, which like Spain and other eurozone countries is now caught in a debt trap – the parlous economic plight that ensues when a country’s cost of capital remains stubbornly higher than the level of economic growth.
As Gave notes, Italy has seen its economy stagnate and its debt levels climb since it joined the eurozone. The country is now heading into its fourth recession in 10 years and, as a result, its tax receipts will collapse, causing its budget deficit to swell.
As he points out, "this will push the cost of capital up even higher, which in turn will depress growth further – the classic vicious cycle of a debt trap.”
But Gave notes, it wasn’t always the case for Italy. Between 1982 and the euro’s beginning in 2000, German and Italian industrial production grew at the same rate. After the two joined the common currency, however, Italy struggled to compete with Germany.
One reason, he says, is that before the common currency, Italy was able to boost its competitiveness by devaluing its currency. Without this option, Italy’s real labour productivity has badly lagged behind that of Germany.
As Gave argues, "with lower productivity and a higher cost of capital, one would have to be brain dead to put a factory in Italy, especially if one knows that the tax rate in Italy is going to go up to try to close the budget deficits… Needless to say, the financial markets have perfectly anticipated this state of affairs and expect the unavoidable re-emergence of the lira.”
Indeed, he says, the current gap between German and Italian bond yields indicates that "a 32 per cent devaluation is already priced into the market.”
But what would happen if Berlin capitulates to pressure, and reluctantly agrees to guarantee the debts of countries such as Spain and Italy?
In that case, Gave says, German and Italian rates would likely converge to an average of around 4 per cent, which has been pretty much constant for most of the past 14 years.
This, he notes, "would imply a massive bull market in Italian bonds and a massive bear market in German bonds. Since the German banks are already not very robust, they need a quasi collapse in the German bond market like a hole in the head.”
But even if Italian bond yields fell to 4 per cent, the country’s problems would not be solved. Italy would still not be competitive against eurozone powerhouses such as Germany.
As Gave argues, "Italy will not be able to grow itself out of its current bind under the yoke of currency which is overvalued for a country like Italy. Which means the structural growth rate will never catch up with the cost of capital – Italy might still have to write off some of its debt.”
However, eurobonds would be even worse for a country like France, where the 10-year bond yield is currently trading at around 2.5 per cent. France would would face a sharp jump in its borrowing costs if it agreed to guarantee the debts of countries such as Spain and Italy.
According to Gave, France’s cost of capital would rise by at least 1.5 percentage points at a time when the country is also heading into recession, "drastically lowering the odds that France can escape a debt trap”.
And Germany would not be spared. Higher bond yields would likely spell the end of Germany’s property bull market, and "with three of its main clients going under one should start worrying about Germany too”.
According to Gave, eurobonds would "make the economic and financial situation far worse than it is today for almost every player – Italy, France, Germany, Spain, Portugal.’
However, he adds, since the idea "is at the same time idiotic and counterproductive, I fully expect the European elites to try and go for it.”
If they do, he says, "I would recommend selling across the board in Europe – currencies, bonds, equities – and become very cautious on the rest of the world.”