In a democracy, elected leaders are meant to implement the will of the people. However, there is a growing anger that the political establishment has long favoured the elite at the expense of a disenfranchised majority.
As a result, there has been a rise in populist politics. Right wing parties have won power in a number of Eastern European countries, and have gained in popularity in the larger economies as well. Brexit and US President-elect Donald Trump are likely to give populist parties a further boost.
Political developments in Italy and France are turning decidedly against the euro as the most popular parties in both countries are promising a referendum on the whether to abandon the European Monetary Union and hence the euro.
The euro came close to the edge in 2012, is Italy the next problem?
The upcoming Italian referendum has the potential to cause another flare up of the European debt crisis. In 2012 the potential for Grexit (Greece leaving the Eurozone) had the markets in a panic. At that stage we felt (mistakenly, in retrospect) that a break-up of the Eurozone was likely.
Italy’s political system has been dysfunctional for a long time, but pressure has been building due to the decline of the economy since the financial crisis of 2008. GDP per capita in the country has fallen 12%.
What’s important to understand is that prior to the formation of the euro, the Italian lira experienced a consistent depreciation relative to the German Deutschmark. As the chart below shows, from 1970 until the euro exchange rates were fixed at the end of 1998, the lira depreciated by 6% per annum.
The founders of the euro underestimated the benefit of a floating exchange rate as an essential rebalancing mechanism. Without the ability to maintain its competitiveness through devaluation, Italy’s economy has festered. This has enabled the rise of populist “Five Star Movement”, which was formed just seven years ago and is now the largest opposition party in the country.
The upcoming constitutional referendum in Italy is important
In Italy a referendum on constitutional reforms that effectively make it easier for the ruling party to pass new laws will be held on Sunday December 4. Prime Minister Mario Renzi does not believe he can govern effectively without reform and has promised to resign if the vote is “No”. Opinion polls suggest that he will lose.
If Renzi loses and resigns this could trigger early elections. Italy’s three main opposition parties are all in favour of exiting the Eurozone. This means that a “No” vote could be the start of a political process to discard the euro. Italy is the third largest issuer of sovereign bonds in the world so any hint of a referendum on the euro will cause the markets to panic.
There is no mechanism to leave the euro
In 2011 the Eurozone represented 19% of the world economy while Greece represented 2% of the Eurozone economy. How did a country which contributed less than half a percent to the world economy cause a crisis in global financial markets? The reason is that there is no orderly mechanism to leave the euro, which means that a crisis in any of the 19 countries has the potential to collapse the entire currency union.
European countries share a common currency, but different governments, treasuries, central banks and banking systems. Those living in the crisis countries like Italy, Spain, Greece and Portugal have shifted their deposits out of the country and into Germany, Luxembourg and the Netherlands. The overall effect of this is that Germany funds the Italian and Spanish banking systems (the target 2 mechanism via the ECB).
The extent of these imbalances that this has created is reflected in the chart below:
The German central bank is owed EUR350 billion by the Italian Central Bank and EUR730 billion by Europe as a whole. These imbalances will increase if the euro crisis intensifies. If Italy chooses to leave the euro, they will likely re-denominate their liabilities into a local currency. This new currency will depreciate relative to the euro, saddling creditor nations like Germany with large losses.
The European banking system, which is already poorly capitalised, will be bankrupted by losses on their government bond holdings. The system is tightly integrated with no mechanism for any country to leave.
Germany has the most to lose from a Euro Breakup
There is a perception that Germany is in a powerful position as it is the unofficial backstop for the ECB and it effectively funds the European banking system. The following chart shows how Germany’s balance has grown from virtually zero in 2006 to its current level in excess of EUR700 billion.
Germany’s position as Europe’s funder has created the appearance that it has a lot of power in the negotiation process. However, JP Getty once said, “If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.”
Italian individuals and corporates hold large amounts euro deposits outside of Italy, while their central bank effectively owes Germany EUR350 billion. It is definitely Germany’s problem. With regard to sovereign debt the main deterrent to default is the resultant economic crisis, which is not much of a deterrent for countries that are already in crisis.
Leaving the euro will be a significant boost to a highly indebted country like Italy. A populist movement in a struggling economy can make a convincing case for leaving the euro and the benefits of debt relief. Sovereign debt is very difficult to enforce if you are not willing to go to war, so Germany (and other creditor nations) will be in a difficult position.
How should we position portfolios in this context?
Our valuation models indicate that the dollar is expensive and the euro is cheap, but what risk premium do you put on a currency whose very existence is under question?
While every effort will be made by politicians and the ECB to keep the Eurozone together, it feels like only a matter of time before one of these events causes the system to collapse. At the very least the prospect of a breakup will be a constant part of the investment climate.
The dollar is the only safe haven currency in this environment so going forward we should be willing to tolerate a far more expensive dollar, given the lack of alternatives.