Europe is heading in to the Great Unknown, as Monday’s post highlighted. The UK, The Netherlands and France are not the only political uncertainties that we face. Elections are also due in Italy and in Germany.
Italian elections. After premier Renzi’s referendum defeat last year, it seems like that Italy will hold elections this year, probably in the next few months. A the moment, the most likely winner is former comedian Beppe Grillo. As I have discussed before, his main policy is for a referendum to exit the euro, but stay in the EU. But, of course, it is also possible that the current Gentiloni government might survive until the scheduled election date in 2018.
If Grillo wins, the entire European banking system is likely to go bankrupt, as well as the European Central Bank (ECB). The reason is that leaving the euro, and returning to the lira, would inevitably lead to a major devaluation of at least 20%. As the ECB is the main owner of Italian government debt, thanks to its Quantitative Easing programme, it also would go bankrupt. As Astellon Capital note, the critical legal issue is that the Bank of Italy is privately owned by the Italian banks – not state owned. The ECB claims the government would still be responsible for the debt, but investors and other governments are unlikely to wait around for Italy’s slow-moving courts to reach a decision.
German elections. In October we then have the German elections, where Angela Merkel is seeking a fourth term. Her credibility has been badly damaged by her handling of the refugee crisis, although most polls suggest she is still the favourite. Germany also has a growing challenge from an anti-EU party, the Alternative für Deutschland (AfD). But her main opponent is the new pro-EU leader of the Social Democratic Party (SDP), Martin Schulz.
A win for Merkel would obviously be “business as usual”. But if Schulz wins, he would bring a new dimension to the political debates over the future of the EU, as he was the President of the European Parliament until he resigned to seek the leadership of the SDP. Whereas Merkel saw herself as a “safe pair of hands”, Schulz is likely to be a more activist Chancellor, if elected. His reputation at the Parliament was of “someone who got things done”. But his actual policy objectives are unclear at the moment.
COMPANIES AND INVESTORS NEED TO PREPARE FOR VERY DIFFERENT OUTCOMES
Voters have got tired of waiting for change to take place. As I noted in November, 69% of Germans, 82% of Italians and 89% of French feel their country is going in the wrong direction. So they are prepared to try different options, just to see what might happen. In turn, this means that Europe, and the world, is entering a Great Unknown. At least 4 quite different alternatives could therefore result from this year’s elections:
Business as Usual. Perhaps Rutte, Fillon and Merkel will win their elections, Gentiloni survive into 2018, and May get her Brexit deal. But this seems just a 10% probability today
A triumph for the Populists. Populist success could continue, with Wilders winning in The Netherlands, Le Pen in France and Grillo in Italy, whilst the AfD wins a strong position in Germany. This is a 25% probability
Smörgåsbord. Each country might go its own way, with Wilders winning in The Netherlands, Macron winnng in France, Gentiloni surviving into 2018 in Italy, and Merkel winning in Germany. This is also a 25% probability today
A New Broom. Wilders wins in The Netherlands and Grillo in Italy, whilst Macron and Schulz win in France and Germany. This is perhaps the most likely outcome, but has only a 40% probability
Each of these outcomes would have radically different implications for companies, investors and us as individuals. The Populist, Smörgåsbord and New Broom outcomes would also give very different outcomes for the Brexit process. It could easily become of only marginal importance for EU leaders, if “business as usual” options disappear. In turn, this would make May’s position back in the UK, very difficult indeed.
Nor can one ignore the potential impact of events, such as a Greek default, or of further interventions by Presidents Trump and Putin. Both would be happy to see the EU disappear. These widely differing alternatives highlight the dangers of continuing with a one-dimensional view of the world based on economics. Political risk has returned, and is likely to continue rising up the agenda for a long time.
We are entering the Great Unknown in Europe over the next 9 months. Everyone will have their own views of the probabilities. But the crucial point is that every country in the world is likely to feel the impact, in some way, if “business as usual” fails to occur. And it will then be too late, at the end of the year, to suddenly wake up to the implications for your business, and for you personally.
“We should not forget the historic nature of what is at stake.
“Its about whether a country can leave the euro zone and what that means for the future of an incomplete and flawed European Monetary Union.
“Its about whether there may soon be a failed state in southeastern Europe with all the geopolitical consequences that could entail in a fragile region.
“Its about whether the EU’s 58-year-old project of “ever closer union” goes into reverse, and whether the objective forces of economic divergence finally overwhelm the political will on which the euro was founded.
“The United States, China and Japan understand what’s at issue and all have expressed concern that Europeans should find a solution to keep Greece in the euro. Yet at this point, that does not appear the most likely outcome…..
“If European leaders effectively abandon a defiant Greece to its fate, neither the euro zone nor the European Union will be the same again. Some, notably among the growing ranks of Eurosceptics around the continent, will think that is for the better. The glee with which Nigel Farage, Marine Le Pen and Geert Wilders greeted the prospect of the unravelling of European integration may give euro zone leaders pause.”
This summary from Reuters’ vastly-experienced European Affairs editor, Paul Taylor, expertly sums up the real issues at stake in Sunday’s final Eurozone summit on Greece.
These have been largely ignored in the on-going arguments about Greece’s debt. Debate has instead focused, understandably enough, on the fact that the Greeks have managed to borrow large amounts of money, at least €322bn ($365bn), and cannot possibly ever repay it. Even worse, the various Greek governments appear to have done nothing to reduce their future spending, or indeed, even to raise a more sensible amount of tax.
It is no wonder that only 10% of Germans want to handover more money to the Greeks, given the history of previous loans. The word for debt in German, “Schuld“, also means “guilt” – and it is understandable that Germans and others across Europe now see Greece as a morality play, where the guilty need to be punished for their crimes.
Yet, with all apologies to my many German friends, this is not the real issue on Sunday:
- Last Saturday, 1600 Syrian refugees landed on the Greek island of Lesbos. Many more thousands are on their way. If Greece leaves the Eurozone on Monday, who will run the reception camps where these migrants now live? Nobody, is the likely answer. The Greek government will be unable to feed and protect their own population, so why should they devote precious resources to these people? Inevitably, therefore, Greece will become an open door for increasing numbers of Syrian/Libyan and other migrants into the European Union
- Equally important is the future of the Eurozone itself if Greece is to be abandoned to its fate. It will then be clear to everyone that it is no longer a currency union, bound together by treaty obligations. Instead, it will have become just another exchange rate mechanism, like its ill-fated predecessor the Exchange Rate Mechanism (ERM). Its fragility was summed up by the UK’s finance minister, who boasted that he went home that evening after leaving the ERM and “was singing in his bath”.
- The third reason why the Eurozone should pause is that Greece in many ways is just the ‘canary in the coalmine’, warning of the flawed construction of the Eurozone itself. As I have long argued, Eurozone leaders should never have set up economic and monetary union without political union. They knew this at the time, but they ducked the issue. Now it has come back to bite them, hard. And if Greece goes, we can be sure that others will follow them, if this fundamental flaw in the design is not now fixed.
Of course it will be difficult for resolve all the long-standing issues created by the Greek crisis on Sunday. But as the Chinese proverb says, “a journey starts with a single step”. And the facts are at least clear:
- Everyone knows that Greece will never pay its bills
- Everyone also knows that Greece will immediately default on its debt if it is forced to leave the Eurozone
- And everyone also knows that taxpayers in the richer Eurozone countries will end up paying the bill as a result – Germany will end up paying at least €86bn, and probably much more
So why take this pain for no gain? Why not instead deal with the cause of the problem – the lack of political union. Why not admit, as Paul Taylor argues, that the Eurozone is “incomplete and flawed”? And having recognised reality, then use the crisis to make a fresh start by agreeing a more sustainable basis for the Eurozone itself?
“Summit fatigue” is a real issue in long-running sagas like Greece. It can easily lead people to sleepwalk into a situation they had never dreamed could happen.
In this case, the risk is very clear and immediate. It is that large numbers of migrants start to pour into N Europe via the relatively safe route from Turkey to Greece. (The United Nations estimates there are now 4 million Syrian refugees, and report that total migrant crossings rose 80% in H1 versus 2015 to 137k). And in turn, their arrival leads within a short while to the triumph of nationalist parties in France, the Netherlands and elsewhere, all determined to exit not just the Eurozone but the European Union itself.
Sunday will be a critical day for all of us who live in Europe. And for the underlying stability of the political structures that have underpinned the world since World War 2.
This morning, Greece introduced capital controls. People can only withdraw €60/day ($65) from their bank accounts. The government has also called a referendum on Sunday, after Eurozone talks on a new bailout package collapsed.
The key issue is that Greece will never be able to repay its debts. These are currently estimated at €322bn ($365bn) – far larger than its economy, which is only $238bn after having shrunk by 25% since 2008. Greece also needs new money to be invested in the country, if it is to make a new start and fund new growth.
If Greece was a company, everyone would know what needed to be done. The business would have to be put into bankruptcy; debt-holders would have to write off some debt and swap the rest for equity; and a new business plan would have to be developed to be funded with new money from existing and new investors.
But Greece isn’t a company, of course. And today’s politicians don’t like to take hard decisions or to deliver difficult messages to their electorates. This is why I feared 2 weeks ago that the “Slow motion Greek train wreck was getting ready to hit another buffer‘. The heart of the problem is very simple:
- Political union in the Eurozone was essential if economic and monetary union was to succeeed
- But although this was rejected by France in the 1990s, the Eurozone project still went ahead in 1999
Politicians instead pretended that political union existed, and banks have since lent vast sums to Greece. And although it has been clear since 2009 that these loans cannot be repaid, they failed to explain this to their electorates. Instead the Greek and Eurozone leaders decided to extend repayment to 2050.This policy of “pretend and extend” means Greece is now bankrupt on an epic scale.
None of us can now know what will happen next. But we can assume Eurozone politicians will continue to try and avoid telling their electorates what has been done in their name. The German part of the bill could easily be €86bn, and in a worst case could be the entire €322bn according to the respected IFO Institute.
But the game of “Pretend and Extend” is clearly complicated by the involvement of the IMF. It is not allowed to lend to countries who cannot repay their loan, and it has powerful members outside the Eurozone in Asia and Latin America, who want it to enforce this rule. Thus Christine Lagarde, the head of the IMF, told CNBC yesterday:
“Our objective is clearly to restore the financial independence, the stability of Greece – to make sure that growth can start again. And that Greece can be sustainable from an economic and financial standpoint. As I’ve said, it is a balancing act. There has to be measures taken by Greece, there has to be support by the Europeans. And they come in sequence. Measures have to be taken, they have to be implemented. And that triggers a different attitude and a willingness to look at both financing and debt sustainability.”
The IMF is thus coming out on the side of those who want realism to be injected into the debate. The Greeks have to develop a functioning tax system, and realistic social policies. In turn, the Eurozone governments have to agree to write off debt and finance the new start. That is the real meaning of Ms Lagarde’s emphasis on the need to look at “both financing and debt sustainability” in sequence.
This is why the concept of political union should have been agreed alongside economic and monetary union. But today, German taxpayers face a different decision – and one that has not yet been explained to them. This is simply that if they don’t refinance Greece, they stand to lose all the money that has been lent to Greece in their name.
Greece’s decision to hold a referendum highlights the impasse that has been reached:
- Greece can only implement one side of the necessary deal – reforming its taxation and spending policies. It cannot come up with the new money needed to reverse the current decline in its economic performance
- The Eurozone is in an equally bad position, as it cannot force Greece to undertake this restructuring. And so it may end up having to write off the Greek debt, and getting nothing in return
This is always the problem with ‘pretend and extend’ policies. In the end, reality has a habit of intruding.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 40%
Naphtha Europe, down 40%. “Values are coming down gradually from recent highs as the product is long and its use in summer gasoline blending is limited”
Benzene Europe, down 39%. “There is still a steady stream of imports moving into the region from the Middle East and India. As a result, some traders believed that this would readjust the current supply/demand dynamic before long”
PTA China, down 29%. “The two major producers Yisheng Petrochemical and Hengli Petrochemical currently have no plans for any run rates reduction in July. This was largely to faciliate cash flow, several market participants added”
HDPE US export, down 19%. “Domestic export prices slipped during the week on oversupply, verified by industry data released on Friday.”
¥:$, down 21%
S&P 500 stock market index, up 8%
Markets have been remarkably calm ahead of Crimea’s planned Sunday referendum to leave Ukraine and join Russia. Yet as Associated Press has reported:
“The Group of 7 world leaders say they won’t recognize results of a referendum for the Crimea region to split from Ukraine and join Russia. A statement from the seven nations released from the White House on Wednesday calls on Russia “to cease all efforts to change the status of Crimea contrary to Ukrainian law and in violation of international law.” It says the referendum scheduled for this weekend “would have no legal effect” and the process is deeply flawed.
“The leaders said they would take further action, individually and collectively, if Russia tries to annex Crimea. The statement was from the leaders of Canada, France, Germany, Italy, Japan, Britain and the United States, along with the European Council and the European Commission.”
This calmness is probably because markets have forgotten that geopolitics matter. And as the old saying goes, “those who fail to learn from history, are doomed to repeat it”.
German Chancellor Angela Merkel used to live in East Germany, before German unification, and she hasn’t forgotten. She warned the European Parliament of potential “catastrophe” yesterday:
“We would not only see it, also as neighbours of Russia, as a threat. And it would not only change the European Union’s relationship with Russia. No, this would also cause massive damage to Russia, economically and politically.”
The Ukraine/Crimea dispute is thus just a first sign of the growing distance between the Have’s and the Have-nots. As the above slide from Branko Milanovic of the World Bank shows, there are 7 major global flashpoints today where this divide is already evident (red dots):
- “First to fourth world: Greece to Macedonia/Albania; Spain to Morocco; Malaysia to Indonesia
- “First to third world: US to Mexico
- “Borders mined or walled: N Korea to S Korea; Saudi Arabia to Yemen; Israel to Palestine”
These flashpoints matter because the key issue in income inequality today is not within countries, but between them. Where we are born and live explains 60% of the difference in personal incomes. Our parent’s income only explains 20% of the difference, as class distinction within countries has reduced in importance.
If we add a red line to Milanovic’s map to divide West and East Europe, we can easily see how his argument applies to the Crimea/Ukraine dispute:
- Europeans are relatively wealthy with GDP/capita averaging around $40k
- Russian GDP/capita is just a third of this at $14k
- Ukrainian GDP/capita is a third of Russia’s at $4k
Ukrainians and Crimeans might therefore easily see themselves in different camps:
- Those who live in Crimea and regard themselves as Russian might choose to join Russia
- Non-Russians living in Ukraine might instead choose to stay independent and hope to link up with Europe
Geopolitical issues like these were generally ignored during the economic boom of the SuperCycle. But now we are transitioning to the New Normal and economic growth has slowed. So geopolitical issues like these are therefore resurfacing and will become increasingly important once more. As Lithuania’s president warned last week:
“Russia today is dangerous. After Ukraine will be Moldova, and after Moldova will be different countries. They are trying to rewrite the borders after the Second World War in Europe.”
Today’s confrontations are probably only a taste of those to come. Relationships between the West and Russia are now clearly set to worsen as Merkel warned. Last week, for example, Russia’s President Putin claimed that Lithuania and Poland had helped to organise the unrest in the Ukraine.
In turn, it is likely that China will see today’s dispute as an opportunity to re-establish its former relationship with Russia. Its ambassador to Germany warned Wednesday:
“We don’t see any point in sanctions. Sanctions could lead to retaliatory action, and that would trigger a spiral with unforeseeable consequences. We don’t want this.”
We can have no idea of how the various strands will play out. But one thing is very clear. Many companies will suddenly wake up in shock one morning, having realised too late that their prized foreign plant is now on the ‘wrong side’ of the growing geopolitical divide.
Last week saw the 20th EU ‘Crisis Summit’. Like the previous 19, it achieved little. Yet everyone at the meeting knew what had to be agreed:
• A banking union which operates across national borders
• The issuing of joint Eurozone bonds, guaranteed by all euro members
• Adoption of a Federal budget and economic policy
These measures would create the essential fiscal union required to support the euro as a common currency.
Equally, this is not a new debate. It was spelt out in 1990 by German Chancellor Kohl and French President Mitterand, when the concept of the euro was first discussed. As the US example shows, monetary and fiscal union also requires political union.
But today, the two countries at the heart of the euro project are as far away as ever from agreement:
• Germany wants to have central controls over spending
• But France will not agree to give up national sovereignty.
Equally, as Reuters notes, the leaders continue to talk different economic and political languages. The ‘crisis summits’ thus resemble the efforts to build the biblical Tower of Babel, pictured above by Breughel.
Thus in German, the word for ‘debt’ is Schuld, which also means ‘guilt’.
So in Germany, the Eurozone debate is a morality play, where those in debt are ‘sinners’:
• It wants the debtor countries to introduce a stability culture of low inflation and low debt, via a savings policy based on austerity
• But new French President Hollande won election on the basis of a ‘growth policy’ based on spending, not savings.
Pensions policy highlights the difference. Germany is raising pension ages to 67 years. Whilst France has just reduced them from 62 to 60 years.
The European Central Bank is caught in the middle. It provided €1tn ($1.4tn) of emergency funding in December to avoid the collapse of the banking system. But it cannot force the politicians to accept the need for fiscal and political union to support monetary union.
Thus as the blog warned a year ago:
“The alternative (to agreement) is not the status quo, as too many politicians still hope. It is that the Eurozone could eventually break up, and in the process severely damage both the European Union and the wider global economy.”
This week’s news provided more evidence to support the blog’s fear that the global economy is close to recession:
• The German economy, Europe’s motor, saw negative growth in Q4
• US retail sales grew just 0.1% in December, despite good auto sales
• China’s auto sales fell in Q4, and house prices fell in 60 cities
Equally worrying is that many policymakers seem blind to the risks of recession. Germany’s Chancellor Merkel, for example, remarked as recently as August that “I don’t see anything which signals a recession in Germany”. Yet only a month later, growth had already stalled.
The reason for this myopia is probably fairly simple. The global economy grew more or less continuously during the 1982-2007 period, and so policymakers are making the fatal assumption that this is ‘normal’.
As a result, their wishful thinking is creating additional risks for the economy as we move into 2012:
• On the Downside lie the risks of a Eurozone break-up, a hard landing in China, and a further downturn in the US housing market
• None of these risks is minor from a chemical industry viewpoint. They all have destabilising potential, particularly in terms of political risk
• Protectionism would be a very strong possibility if any of these areas went seriously wrong
• On the Upside, policymakers might panic if these events occurred
• They might undertake further stimulus efforts, on a massive and perhaps co-ordinated scale
• In terms of scale, they might each do a minimum of $500bn, making $1.5trn in total
None of us can judge the likelihood of the above events. They are like leaving a series of banana skins at the top of the stairs, and wondering whether anyone will fall and break their leg as a result.
The best response is perhaps to continue with a Base Case scenario that is based on the arrival of recession. A Downside scenario would then reflect the risks above, just as would the Upside scenario.
It is all a very long way away from the comforting consistency of the Supercycle days. But to do nothing in the face of the banana skins around, could also prove to be wishful thinking as well.