May 29, 2012

What’s Next for Europe? Look at the Eurozone Countries’ Numbers

The epicenter of the economic and markets news these days is certainly located in Europe. Although this issue has been with us for several years, it seems as though we may be approaching the critical hour. Most of us are aware that borrowing from Peter to pay Paul will only work if Peter is willing to lend. However, if Peter thinks the risk is too great, he will not lend, or he will require a higher rate of interest to compensate for the additional risk. This is precisely what has happened in Europe. 

Europe may be divided into the stronger countries of the north and the weaker ones to the south. The table below shows the rate of interest on the 10-year government bond for several European countries.

Note the drastic difference in the cost of borrowing for the first six countries as compared to the bottom seven. For example, Germany's government can borrow money for 10 years for only 1.37% while Spain has to pay 6.31% and Greece...well...let's just say they probably don't have too many takers. Obviously, countries saddled with paying higher rates cannot sustain this indefinitely. 

There has been a lot of discussion over the creation of a ‘Eurobond.’ However, I don't believe we'll ever see it. Why? Because it would reward the weaker countries and punish the stronger ones. How? The interest rate on a Eurobond would have to factor in the credit risk of all countries involved. The resulting rate would certainly be higher than that of the stronger countries and lower than the weaker nations. In essence, it would increase the borrowing costs of the stronger countries. 

Would Germany accept this? Not likely. However if the present course continues, it's probable that some weaker countries will exit the eurozone, which would lead to a stronger euro, but would hurt exports of the remaining nations. Moreover, if a weaker nation were to leave, they would revert back to their former currency, which would likely weaken initially, causing inflation and economic suffering.

The most relevant question to the stronger, larger, more powerful nations in the eurozone is this: "Is it less expensive to allow a country to leave the eurozone or to continue to prop it up through a re-distribution of wealth (i.e., bailouts)?" 

Until then, as Europe continues to make headlines, I believe risky assets will continue to struggle, although with occasional ‘pops,’ but the trend will be negative. 

 

 

 

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