The EU leaders are most likely close to key decisions about the future of the euro. The financial rescue package announced during the Greek episode of the crisis last year was designed to buy time in order to work on solving the fundamental problems. That package was not enough to stop the crisis domino at Greece. With that domino getting very close to Spain, the time bought seems to be running out. Despite the fact that the EU Finance Ministers meeting produced no changes to the rescue fund, there are indications that something significant is coming. Eurogroup head and Luxemburg’s Prime Minister Jean-Claude Juncker is reported saying that a solution to the euro debt crisis is weeks away. Markets seem to believe some improvement is coming (the euro recovered from 1.29 USD/EUR earlier this month, to almost 1.36 today).

There is always room for innovation, but the possible scenarios range from serious fiscal integration (more bailouts) to debt restructuring (with or without euro exit). The German government appears to have changed its position on this subject recently. German officials had stated that increasing the size of the EFSF (the rescue fund) was not necessary, or that it was too early, while some interpreted that to mean Germany could not fund an increase for internal political reasons. Recently, that position seems to be changing towards a “let’s save the euro” one. Though Germany seemed reluctant to provide more funding, the reality is that having poorer indebted countries within its currency union has benefitted German exports (without weaker links in the union, the currency would be significantly stronger).

Letting countries restructure unsustainable debt seems the right thing to do. But when a country is part of a young monetary union with very imperfect institutions, things get a bit more complicated. Especially when the group of countries fiscal or private debt burdens that could be seen by the markets as unsustainable is not small, and can actually grow to touch on bigger more central countries. Moreover, the debt that might be restructured sits in banks balance sheets across the region, especially in the UK, Germany, France and Spain. Seeing this debt problem as the European counterpart of the US mortgage debt problem of 2008 is not misplaced, as many of the fundamental causes of both crisis are the same[1].

We have repeatedly highlighted the risk of coordination failure at the policy making level. Internal politics or fundamental differences of opinion could always produce a very negative outcome when crisis management is in the hands of a collegiate body without the structure and experience to deal with regional economic crises. This is the reason this ‘euro crisis’ has already taken over a year to develop and has moved through a domino of countries that is now getting dangerously close to the core of the EU, threatening the survival of its main ideals and the currency.

Debt restructuring of one or more countries could produce a very negative effect in the markets for debt of the next countries in that domino, not to mention bank deposits in all suspect countries. This is most likely the key reason behind the recent changes from tough to helper. What is decided and announced over the next few weeks could be critical for the euro, and potential global markets. This is the reason we have not rushed to increase our risk exposure across the board while fundamentals away from the EU granted such move. Our global equity exposure remains around 30%, commodities below 10%, though we have maintained a relatively high exposure to the emerging markets across both debt and equity, despite its higher beta[2].

As we said many times, the fundamental problems of the euro are in its fiscal institutions and economic structure differences. A mechanism that would reduce the discrepancies across countries while drastically increasing fiscal discipline is difficult to produce and would take a long time to show results. The short-term most likely requires a larger commitment from the rich countries. But the fate of the euro in the medium term continues to depend on institutional reform.

Debt restructuring that produces a short-term shock to markets is still a possibility, though its probability seems to be falling in the short term. The decisions and EU politics of the next 2-3 months are very important for the euro, its region, and to some extent global markets.

[1] This is a more complicated and lengthy topic to be discussed here. An excellent book on the fundamental causes of these crises is “Fault Lines: How Hidden Fractures Still Threaten the World Economy” by Raghuram Rajan, 2010.

[2] Our performance during 2010 was an average return of slightly above 10%, with half the volatility of the S&P500 (volatility of daily returns was 10.3% annualized).

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