AMSTERDAM—European economic data was upbeat last week as both consumer confidence and the composite Purchasing Manager Indices (PMI) for the eurozone managed to surprise on the upside.
While consumer confidence remains deeply negative at -20.6, the PMI coming in at 50.4 actually managed to climb back above the 50 mark, which signals economic expansion. Germany had an especially strong showing here whereas Italy and Spain remained sluggish. The two peripheral countries also reported disappointing retail sales providing further evidence of the split in economic reality between the core and the non-core eurozone countries.
This divergence was exemplified by another abysmal Spanish unemployment figure, which had been preannounced by Prime Minister Mariano Raroy the week before last. The number increased from 21.52 percent in Q3 2011 to 22.85 percent in Q4 2011, a simply astronomical figure. Many economists attribute this sad state of affairs to the excessive employment protection of the elderly, which prevents young people from getting jobs.
Good Data Positive for Euro
The euro bounced from its oversold position and rallied straight up from the low last Monday of $1.2855 to $1.3174 last Friday afternoon. This marks a 1.88 percent gain for the common currency against the greenback, which according to analysts was fueled not only by a snapback of speculative shorts in the futures market, but also by the Federal Reserve’s decision to hold interest rates at zero percent until 2014. Interest rate differentials are an important driver in foreign exchange markets and the European Central Bank (ECB) still has the main refinancing rate at 1 percent.
The Euro Stoxx equity index could not keep up with the blistering performance of the euro and only gained 0.4 percent for the week closing at 2,437. Since this benchmark index is made up of companies from all countries, weak peripheral markets overshadowed the strong showing of the German stock market, which rose 1.68 percent for the week because of the economic data.
Dramatic Developments in Greece
Negotiations between the private and the public sector were ongoing last week about how to reduce Greece’s debt burden avoiding a so-called “hard” default, which would likely trigger credit-default swaps—an insurance against losses on bonds—and wreck banks’ balance sheets.
Both parties seem to have agreed that the private creditors must realize some losses and swap old bonds for new bonds to make the debt load more manageable. But the devil lies in the details and European finance ministers last Monday rejected a proposal by the banks to receive new bonds with a coupon in excess of 4 percent.
Last Wednesday, another proposal was made, reducing the coupon to under 4 percent, but demanded the participation of the ECB according to Greek daily Kerdos, something that the central bank wants to avoid at all costs. And while this position from the public side seems to be set in stone, banks are also inflexible, with the chairman of BNP Paribas Group suggesting that bondholders would not easily change their position.
Deadlock Due to Difficult Incentive Structure
The protracted negotiations can be explained by the fact that both parties are facing inconsistent incentives and are trying to gauge and exploit the weakness of the other party. In theory, the refusal of the banks to take some limited losses in an organized restructuring does not make sense considering that the losses would be even larger in the event of a hard default.
By now, however, the public sector including the ECB and the EU also have large exposure to Greece that is in some cases in the form of direct loans senior to bondholders. The ECB owns some Greek bonds outright and has much more deposited as collateral in exchange for financing predominantly granted to technically insolvent Greek banks. In the case of a hard default, the ECB would incur massive losses on both bonds held outright and collateral and the EU would not be able to recoup the full amount of its loans. On the other hand, the private sector already wrote down much of its losses and can expect to recoup some more if the credit default swaps trigger.
These facts greatly help the private sector, which also knows that the public institutions are fearful of collateral damage and precedent. A hard default could cause political unrest and also lead other countries to go down the same road, Portugal being the prime example. Banks and other private holders would also lose out in such a scenario but the risks here is spread among more players and not concentrated among a few institutions.
This was pointed out by former IMF chief economist Kenneth Rogoff at the Davos World Economic Forum last week when interviewed by Bloomberg TV. “Once you set the precedent then say Portugal is going to say ‘Hey, look how much you gave Greece. How come we don’t get the same?’” He further went on to say that despite the measures taken by the private sector, the continent is “clearly unprepared for a Greek default” and that money printing was not a sustainable solution.
Predicting the exact outcome of the negotiations is difficult, but according to BBC sources in the U.K. foreign office, German Chancellor Angela Merkel is already preparing for a hard Greek default.
The Week Ahead
This week, economic data will be light, but Italian unemployment figures as well as Spanish Q4 GDP data could provide some negative surprises. After Davos last week, we will see a Brussels meeting of EU leaders on Monday.
Thanks to the liquidity injection of the ECB, sovereign bond auctions have been rather quiet as of late. So there should not be any surprises when Italy auctions off 5 billion–10 billion ($6.5billion–13 billion) on Monday and Spain taps the market on Thursday.
