There May be no Free Lunch, But is There a Magic Wand?
By the late-1990s it became clear to informed observers that the some portion of the EU countries that had signed the Maastricht Treaty in 1992 were going to proceed with a European monetary union (EMU) as codified in the Treaty, most probably on schedule, in 1999. Previously dismissed as a Franco-German political pipe-dream, there was a growing air of excitement in financial markets as the EMU countdown began. But on the trading floors of banks and in the boardrooms of asset management firms, such excitement quickly gave way to the practical reality of how best to prepare for the euro. What were the implications for the participating economies? Their financial markets? How would the euro trade as a currency? How would the various national bond and equity markets trade vis-a-vis each other? Most importantly for investors, what were the risks involved? The opportunities?
At the time, I was working as an investment strategist in Germany and it was in this context that my colleagues and I set about developing EMU-specified financial market analysis tools. The first, most obvious problem that had to be dealt with was, if you create a single currency out of several, what happens to the intra-EMU FX risk? After all, in 1992 and 1995 there were major EU currency crises. These had made (or lost) bond and currency traders a fortune.
But wait. Doesn’t the FX risk just disappear, as if European policymakers had waved a magic wand? Well, no. Just as there is no free lunch in economics generally, there is no magic wand in economic policy. Policymakers who claim otherwise are like magicians distracting their audience. As is the case in the physical world, in which there is conservation of energy–the first law of thermodynamics–there is also conservation of economic risk. It cannot be eliminated by waving a magic wand. It can, however, be transformed from one type of risk to another.
With respect to EMU, if the FX risk does not simply disappear, where does it go? Consider what creates FX risk in the first place: Currencies fluctuate for a variety of reasons which ultimately boil down to relative rates of sustainable economic growth and expectations thereof. As the EU economies have fluctuating relative growth rates, this creates fundamental FX risk. Only by eliminating these fluctuations could the real, underlying relative economic risk also be eliminated. But if these fluctuations are not eliminated, the risk remains. Once again we ask: Where does it go?
The answer, as it turns out, is credit risk. When a country’s relative sustainable growth rate (or expectations thereof) declines and the currency devalues it improves the terms of trade and, as such, raises the expected future growth rate. This in turn increases inflation and tax revenue expectations which make it easier, in principle, to service debt denominated in the domestic currency. As such, other factors equal, as a currency devalues, domestic credit risk declines in tandem.
But consider now what happens in EMU. A country that underperforms cannot devalue. There is no improvement in the terms of trade and hence no increase in either inflation or tax revenue expectations. Indeed, these are more likely to decline. Debt service thus becomes more rather than less onerous. Credit markets thus demand a higher risk premium to hold the debt. Unless steps are taken to improve relative economic competitiveness, this higher risk premium may remain in place indefinitely, draining resources from the economy and reducing the future growth rate. Ultimately, the only ways to break out of a vicious circle of economic underperformance and higher relative borrowing costs is either to secede from EMU and devalue or to restructure the debt. In either case the fundamental risks are ultimately realized.
This is what is happening in Greece and Ireland today. It might soon take place in other EMU member countries. Those investors who have understood that EMU did not eliminate but rather transformed economic risk and who observed the chronic relative economic underperformance of Greece and certain other euro members were well-positioned to profit from the onset of the euro sovereign debt crisis.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]