Introduction: What will happen to the EU again?
Poker Introduction: After the merger of East and West Germany, Germany truly rose thanks to the euro (of course, even without the euro, a pragmatic Germany would still rise, but it’s only a matter of time). The greatest significance of the euro for Germany is the implicit “subsidy” of a low real exchange rate, while for other euro countries it is the suppression of an overvalued exchange rate.
The “poor” euro weak countries relying on political votes and welfare to feed voters is unsustainable, and the debt has flooded the country’s face. The debt will eventually be exchanged, it just depends on how it is done.
Trump’s anger at Merkel’s manipulation of the exchange rate is not entirely unreasonable. Perhaps it is a helpless move for France for the right winger Le Pen to take office.
Poker investors continue to monitor the progress and impact of the European elections, as opportunities always arise with change.
On the surface, Germany appears to be the growth engine of the EU economy and has contributed a significant amount of fiscal expenditure and financial output to the EU. But in reality, the ‘invisible’ benefits that German countries have gained from using ‘European pig’ countries far outweigh these ‘visible’ financial costs.
In the previous article ‘Rolling up sleeves and pulling wool: What trading opportunities are hidden in the European political’ black swan ‘?’, we discussed three topics:
A good economist should consider both visible and invisible consequences simultaneously;
- The economic uncertainty in Europe is decreasing, and Germany is even facing the problem of economic overheating;
- The uncertainty in Europe has shifted from economy to politics on the surface, and in the face of the ‘black swan’ in European politics, there are possible ways to respond and development directions.
The first two points are actually used to illustrate the foundation of the third point. Recently, the market’s attention has focused on whether Le Pen, known as the ‘French version of Trump’, will be successfully elected as the President of France, and whether German Chancellor Merkel, who shoulders the banner of the European Union, can be re elected. After all, both are directly related to the stability of the EU system and even the fate of the eurozone.
Lie to me once, your shame; Lie to me twice, my shame; Lie to me three times, our shame. “- Stephen King
Fund managers who have been deceived twice by Brexit and the US election can no longer calm down. It is understandable to bet twice, but if they make the same mistake in the third bet, not only will they lose face, but they will also lose their golden rice bowl.
As a result, in the face of personal jobs, the potential gains/costs of hedging transactions can not be ignored. Asset managers have entered the market to hedge the Black Swan risk elected by ‘French Trump’, sell French treasury bond and buy German treasury bond.
As a token, the difference between the yields of French and German treasury bond has been rising all the way (I will not repeat it here. For details, see “Roll up your sleeves to collect wool: What trading opportunities are hidden in the European political” black swans “.
Why is the market so sensitive to the French election?
The political stance of far right candidate Le Pen, who is anti globalization, anti immigration, and anti EU, may exacerbate political turmoil in Europe and even lead to the disintegration of the eurozone. The market is concerned about a black swan event in the French presidential election, similar to last year’s Brexit and US elections. The latest poll shows that Le Pen’s approval rating in the second round of elections has increased, although still lagging behind, the gap between her and other candidates’ approval ratings has narrowed. Although the market generally expects Le Pen to win in the first round but lose in the second round, the popularity of Le Pen in the second round of the general election poll has risen, suggesting that her winning face is increasing, which is an important reason for the rise of the interest margin between French bonds and German bonds.
Economist Jean Messiha, the drafter of Le Pen’s 144 electoral procedures, mentioned in a recent interview that if Le Pen wins the election, they will negotiate with the EU to determine a new monetary policy framework, and even establish a new franc. He also mentioned that the eurozone has almost collapsed in the past few years, and the ultimate disintegration is only a matter of time. By contrast, being prepared for the end of the eurozone is always better than simply waiting for its demise.
Cinzia Alcidi, an economist at the European Policy Research Center, used the term “doomsday” to describe the post Brexit eurozone in France (although to add, economists should not take the term “doomsday” too seriously, as last year’s Brexit economists also referred to it as “doomsday”): “The leaders of the eurozone did everything they could to prevent Greece from leaving the eurozone because they were afraid that the eurozone would split, and France is much larger than Greece. If France leaves the eurozone, considering the size of French banks and their relevance to the entire eurozone, the entire banking system in Europe will be in turmoil, and Italy and other countries may imitate France’s departure from the eurozone, and the problem of sovereign debt default will be unavoidable. Even if Le Pen is unable to implement all of her policies, namely France not leaving the EU, the ultimate possible outcome will be endless negotiations, severe economic downturn and high uncertainty in the eurozone. ”
Once the euro area disintegrates, the monetary unit of French treasury bond may be converted back from the euro to the franc with lower potential value and higher interest rate, while the monetary unit of German treasury bond may be converted back from the euro to the deutsche mark with higher value and lower interest rate, which is one of the reasons why German treasury bond have been popular among investors recently (although I agree with the risk aversion of German treasury bond, I do not think it is a good market opportunity from the perspective of investment, and the reasons will be discussed later).
At present, the value of the euro is jointly determined by the international relative productivity of ‘advanced’ European countries (such as Germany) and ‘peripheral’ European countries (such as Southern Europe) (see the following paragraphs for details). In short, if the euro disintegrates, German and French bonds will face revaluation caused by the change of monetary unit.
Exchange rate imbalance – the Achilles’ heel of the eurozone
There are significant differences in the proportion of exports to GDP among countries in the Eurozone, with northern countries such as Germany, Ireland, and Belgium having the highest proportion of exports. In the eurozone with a single exchange rate mechanism, there is a serious problem of currency misalignment/exchange rate imbalance among member countries.
Currently, the Eurozone is facing an overall overvaluation of the exchange rates of southern countries represented by debtor countries such as Greece and Italy (resulting in export losses), and an undervaluation of the exchange rates of northern countries led by creditor countries such as Germany (resulting in export advantages). Due to the productivity differences between euro countries, exchange rate adjustments cannot be made in the market, resulting in the current dilemma where the strong are stronger and the weak are always weaker.
Except for the initial period when the real exchange rate of the eurozone was lower than the equilibrium exchange rate, the real effective exchange rate of the eurozone was overvalued for most of the time (see the figure below). Due to the fact that the productivity of northern EU countries is much higher than that of southern EU countries, Europe’s globally competitive export-oriented countries (such as Germany) have significantly increased the overall exchange rate of the eurozone (relative to the original currencies of other European countries). This has harmed the underdeveloped ‘European Pig’ teammates in southern Europe, causing them to lack competitiveness in the international market due to overvalued exchange rates.
On the surface, Germany appears to be the growth engine of the EU economy and has contributed a significant amount of fiscal support and financial capital output to the EU. But the ‘invisible’ export competitiveness advantages that Germany has gained by using ‘European pig’ countries to lower the euro exchange rate (relative to the German mark) far outweigh the ‘visible’ financial costs. The EU’s’ oil tanker ‘Greece seems to have received a large amount of financial aid, but due to its lower productivity compared to Germany, coupled with the German standard euro exchange rate, it makes it difficult for Greece’s real economy to develop.
Tragic Italy – A Typical Example of Plucking Pig Hair
Let’s do an example dissection based on my personal favorite cute Italy.
As one of the three giants of the Eurozone and also one of the five European Pig countries, Italy’s per capita real GDP has hardly grown in the past decade since joining the Eurozone. But in the same situation, Germany and even France, although not smooth sailing, have steadily grown. There are cultural factors involved, but the most important one cannot be ignored is the exchange rate issue.
The exchange rate, as a lubricant for competition between countries, plays a major role in balancing the competition between nations. When a country has an advantage in a certain industry, such as manufacturing, and other factors remain unchanged, its international competitiveness will weaken due to currency appreciation. Similarly, relatively weak countries can maintain their competitiveness by experiencing a decline in exchange rates. However, countries with varying levels of productivity in the eurozone are required to use currencies of equal value. Countries that were originally highly competitive become stronger due to artificially maintaining their currency at a low level, while weaker countries become weaker due to their currency being artificially maintained at a high level.
The real deadlock in the eurozone economy is the exchange rate. The following simple diagram can illustrate the reason. The deep blue line represents the production index of Italy compared to Germany. Rising can be understood as Italy’s industry being more prosperous than Germany’s, while conversely, Germany’s industry is more prosperous. The green line represents the exchange rate of the German mark to the Italian lira. An increase represents a depreciation of the lira. The unified use of the euro since March 1999 indicates that the exchange rate is no longer fluctuating.
From the above chart, it can be seen that from March 1979 to March 1999, Italy joined the European ERM (to reduce exchange rate fluctuations and increase financial stability). Although Italian industry never had much competitiveness against Germany’s strong industry, due to floating exchange rates and slow currency depreciation, the overall Italian industrial production index remained stable over those 20 years. But since joining the eurozone, Italy has lost its floating exchange rate (unified use of the euro), making its industry unable to compete with Germany.
The decline of Italy is not only reflected in industry. The decline in industry has led to an increase in private and public sector borrowing, resulting in an increase in bad debts. It not only spreads to the financial industry but also to other industries, causing the entire economy to fall into a vicious cycle. It is difficult to imagine any possibility of a qualitative change in the Italian economy in a short period of time when the exchange rate cannot be adjusted.
On the other hand, in fact, as early as 2000, Germany was still known as the “sick man of Europe” – throughout the 1990s, Germany’s economic growth rate was lower than the EU average, manufacturing industry shrank, and unemployment rate reached double digits. In terms of exports, apart from Volkswagen and Siemens, it is also widely accepted. In 2000, Germany’s trade even showed a deficit. At this time, Germany was still struggling to absorb the impact of the merger of East and West Germany, while also suffering from the “appreciation” of the German mark relative to other European currencies. And the soon to be born euro will become an important driving force for Germany’s “turnaround”.
Although the official circulation of the euro in January 2002 did not immediately reverse Germany’s predicament (the German economy continued to stagnate for the following two years), it created an extremely favorable environment for Germany. The exchange rate of the euro can be seen as the “average” of the currency exchange rates of each member state. As the German mark belongs to the downward averaging currency category, the competitiveness of German products is immediately enhanced when the euro is adopted: German products immediately become cheaper while products from countries with low exchange rates become more expensive. In the year when the euro was officially adopted, Germany achieved a trade surplus.
With Germany’s’ resurgence ‘, the deficits of southern eurozone countries such as Greece, Portugal, Spain, and Italy have grown in sync with Germany’s surplus. In theory, as trade surpluses accumulate, trading partners can automatically adjust their exchange rates and prices. However, in the eurozone, “weak countries” cannot adjust their trade through currency depreciation, and due to political reasons, they cannot suppress wages and welfare levels to lower levels than Germany. Therefore, the economies and employment of these southern countries were constantly squeezed by Germany, which triggered the European debt crisis after reaching a certain critical point.
Why was this fundamental contradiction overlooked when designing the euro in the first place?
The essence of the eurozone problem lies in the fact that countries use a unified currency but have different labor productivity. The theory of “optimal currency area” proposed by the father of the euro, Mundell, holds that as long as production factors within a region can flow freely, countries within the region can automatically correct macroeconomic imbalances without the need for monetary and exchange rate policies.
However, the theoretical assumption in Mundell’s theory that labor can move freely in Europe differs greatly from reality. The segmentation of language, culture, and nationality causes market segmentation, and labor cannot actually move freely (even if the labor itself is willing, the importing country may not be willing to protect the employment of its own people, such as in the UK).
In the situation where labor cannot move freely, each country in the eurozone actually has its own potential exchange rate. However, after the establishment of the eurozone, a unified currency – the euro – was used, which led to undervaluation of exchange rates in high labor productivity countries and overvaluation of exchange rates in low labor productivity countries, further exacerbating foreign trade differences.
According to the “optimal currency area” theory, joining the eurozone means giving up the decision-making power of monetary policy (including exchange rates and interest rates) and relying solely on fiscal policy to achieve a country’s macroeconomic control goals. Although strict regulations on fiscal discipline were established in the Maastricht Treaty and the Stability and Growth Pact to prevent countries in the eurozone from abusing their fiscal policies, weak countries (especially those that did not take advantage of the exchange rate advantage) took advantage of the low interest environment in the eurozone to issue large amounts of debt to maintain high welfare, resulting in a high proportion of fiscal deficits to GDP in the absence of other effective regulatory measures and high levels of social welfare. In 2014, the government debt ratio in the Eurozone reached a peak of 92%, and the debt problem became increasingly severe.
The artificially low interest rate of treasury bond and the debt crisis at any time
After joining the eurozone, countries abandoned independent monetary policies, and the interest rate policy of the European Central Bank must simultaneously consider the economic conditions of all eurozone countries. This has led to the previous article “Rolling up sleeves and pulling wool: What trading opportunities are hidden in the European political ‘black swan’?” mentioning that the German economy is already facing economic overheating, and the European Central Bank has to maintain or even continuously increase monetary easing policies to take care of the economic capacity of ‘backward’ countries.
The loose monetary policy has artificially kept Germany’s real interest rates at ultra-low levels, even to negative values (as shown in the figure below, but for details, please refer to “Rolling up sleeves and pulling wool: What trading opportunities are hidden in the European political ‘black swan’?”). In a stable period, in order to seek ‘real positive returns’, the excess liquidity in the eurozone flows towards the bonds of relatively higher yielding’ backward ‘countries, pushing down the sovereign bond yields of these countries.
Before and after the establishment of the euro zone, the yield of Germany’s 10-year treasury bond has been falling all the way, and the yield of treasury bond of various countries has also moved closer to that of Germany’s treasury bond. Even though the economic conditions of the ‘European Pig’ countries are far apart from those of Germany, the difference in borrowing costs is not significant, which has allowed for a huge increase in welfare spending leading to a surge in total debt.
However, as shown in the figure above, once the crisis is imminent, the hot money will withdraw to avoid risks, and the market will start to sell ‘European pig’ treasury bond and buy ‘German’ treasury bond. While the yield of German treasury bond is constantly decreasing driven by safe haven funds, the yield of ‘European pig’ treasury bond has risen sharply in the crisis to reflect its real sovereign risk. This situation has occurred in various crises since the establishment of the eurozone, such as the 2008 subprime mortgage crisis, the 2011 European debt crisis, and the current political turmoil in Europe.
Once the EU faces substantial disintegration, the borrowing conditions of each country will return to levels corresponding to their own productivity, debt leverage, and potential risks. The borrowing interest rate of the heavily indebted and slowly developing southern European countries will rise significantly (just like the recent interest rate of French and Italian treasury bond to that of German treasury bond), and their debt repayment burden will become more severe due to the huge debt stock and inertia welfare expenditure accumulated in the past ultra-low interest rate environment.
Back to today’s protagonist, due to the large gap between Germany and France in terms of economic potential and financial status, in addition to the revaluation of the monetary unit (from euro to franc, from euro to mark), its treasury bond bond yield may also be readjusted to reflect the real ownership risk of both countries. At present, due to a series of political disturbances within the EU, the bond yields of European marginal countries have risen, and the gap between them and the yields of German treasury bond is widening, but there is still a distance from the real ‘potential’ financing interest rate, especially after considering the conversion of monetary units. This also explains why some time ago, when Le Pen’s election was hot, investors flocked to German treasury bond whose real yield had been significantly lowered.
Overconcentration of Eurozone Capital – Fragile Interbank Clearing System
The European Central Bank’s Target 2 balance sheet is a relatively intuitive and convenient tool for observing capital flows within the eurozone. Target 2 is a clearing system used by commercial banks within the Eurozone for Euro payments. We can understand its principle from a simple example. Suppose a customer wants to transfer 100 euros from their country 1 commercial bank to their country 2 commercial bank. As it is a cross-border payment, the central bank of the country will be involved. The transfer of 100 euros will reduce (increase) the liabilities of Country 1 (Country 2) commercial banks and their reserve requirements at the Central Bank of Country 1 (Country 2). The central banks of the last two countries will liquidate this transaction on the balance sheet of the European Central Bank. In the Target 2 system, after this transaction, the European Central Bank owes 100 euros to the central bank of Country 2, while the central bank of Country 1 owes 100 euros to the European Central Bank.
Imagine what would happen in the Target 2 clearing system if residents of Country 1 continuously transfer money from their accounts in Country 1 commercial banks to their accounts in Country 2 commercial banks?
As shown in the figure below, during the European debt crisis (2011-2012), residents (mainly in southern European countries) lost confidence in their own banks and continuously transferred their assets to banks in countries such as Germany and the Netherlands. Therefore, the positive balances of Target 2 in Germany and the Netherlands continue to rise (the European Central Bank owes money to the German/Dutch central banks), while the negative balances of other small European countries continue to increase, resulting in Germany’s Target 2 “surplus” reaching as high as 750 billion euros at one point. At that time, capital was mainly influenced by risk aversion and flowed into German assets through various means. The most obvious is the decrease in deposits in “European pig” countries, while deposits in German commercial banks have surged. It can be seen that the more potential risks the eurozone faces, the more liquid capital in Europe tends to flow into Germany.
Generally speaking, without the European Central Bank, the banking industries of small European countries would inevitably collapse due to significant cash outflows and the inability to raise funds in the market. But due to the existence of the European Central Bank, these banks can provide financing to the European Central Bank through national central bank collateral assets/securities. Therefore, although the balance of Target 2 appears to represent cash flows between European banks, the true meaning behind these data is that small European banks are continuously financing the European Central Bank due to capital outflows. (Note: The increase in balance after 2015 is mainly due to the European Central Bank’s QE, which is not related to this article and will not be presented here)
Assuming that Country 1 Commercial Bank collapses due to Country 1’s Brexit (with the European Central Bank no longer providing financing support), and Country 1’s central bank is unable to repay its balance after Brexit, the central banks of other countries remaining in the eurozone will bear this loss. That’s why European Central Bank President Draghi has previously emphasized that if any country withdraws from the EU, its Target 2 balance must be repaid. But if in extreme cases, such as a split in the eurozone and most countries deciding not to pay back their debts, according to the data in the chart, Germany will bear most of the losses in this situation.
The imbalance of Target 2 itself is not a problem, after all, the current European Central Bank will provide a fallback. But once there is a split in the European Union, the banks of small European countries will suffer greatly without the European Central Bank’s support, and ultimately the risk will be concentrated in the balance sheet of the German central bank. Once the risk erupts, the German central bank may have to bear a significant amount of paper losses (the total balance of Target 2 in Germany is equivalent to one year’s GDP or 50% of the total assets of the German central bank).
The essence of the EU’s’ black swan ‘lies in the mismatch between human design and the real environment:
a. Labor is not as freely mobile as the designers of the euro imagined;
b. The eurozone is constrained by a unified monetary policy, which leads to overvalued or undervalued exchange rates among countries, further exacerbating trade imbalances;
c. Due to the transfer of monetary sovereignty and the EU’s fiscal policy restrictions, countries are unable to adjust their interest rate policies or even stimulus/bailout policies according to their own situations;
d. Meanwhile, due to the eurozone’s excessive reliance on imbalanced loose monetary and fiscal expansion policies, it has led to high welfare inertia spending and a continuous accumulation of debt stock;
e. However, the yield of European treasury bond is artificially depressed by the overflowing liquidity in ordinary times, which does not reflect the real sovereign risk. Once the uncertainty comes, the hot money starts to withdraw, and the yield of ‘European pig’ treasury bond starts to soar, which in turn makes them bear the double pressure of increasing debt service burden and weak economic recovery at the same time in difficult economic times;
f. We have to pay tribute to the ‘conservative thinking’ of the British, who initially did not believe in the artificially created concept of the euro and resisted immense pressure to not join the seemingly beautiful eurozone.
g. At present, it seems that there is only one unfortunate solution, which is to kick weak countries out of the Western European club, namely the restructuring of the European Union and the disintegration of the eurozone;
h. But theoretically, there is actually another more friendly solution. That is, weak European countries can unite and use the political rights granted by remaining in the EU to blackmail German countries into paying more visible costs while enjoying the ‘invisible’ benefits of low exchange rates and zero market restrictions (but this is likely to cause German voters to explode).
Finally, it should be noted that Le Pen’s right-wing political platform is actually very similar to Trump’s (as shown in the figure below). If Le Pen were to be elected, it would not be detrimental to France, which is excessively left leaning, in the long run. A famous fund manager commented, ‘France has almost gone through all the worst economic policies that economists can think of in the past decade. If a right-wing president with some economic knowledge takes office, after the initial market turbulence, France, whose economic vitality has been suppressed for a long time, will have good investment opportunities.’.
Recently, one political black swan after another has emerged in Europe, with the equally highly uncertain German election following the French election. These ‘black swans’ are hardly good news for the European economy, but for investors, regardless of whether they are black or white swans, anything that can lay eggs is a good swan. Afterwards, I will try to talk about the risks and opportunities in the European political black swan market.