Nowhere to run, nowhere to hide, in Europe

Satyajit Das, an internationally renowned derivatives expert and the author of Traders, Guns and Money, says the European bank stress tests were a sham. In this interview, he speaks with DNA on the predicament of the world at large.

What do you think of the recent stress tests carried out by the European Union tells us?
The tests were rigged. The definition of capital was generous. It should have been done on net tangible equity (share capital after writing off all intangibles like goodwill and tax benefits and excluding debt masquerading as equity). Sovereign default was excluded because that couldn't happen. That's like carrying out a crash test on a car on the basis that there will be no crash! Greek debt was stressed at a loss of 23% when it is trading at much lower levels. If they were to default the losses would be 50-80% based on other sovereign defaults.

The markdown on property values was nowhere near aggressive enough. The big fudge was that the stress tests were predominantly on the trading book, where banks hold trading assets that are available for sale. Bonds and loans that are in the banking book, that is, held to maturity, were not stressed. 90% of the sovereign debt is sitting in the banking book. The whole point was to "reassure" the markets that the European banking system was fine. The only thing the tests have confirmed for me is that the European Central Bank (ECB) and the European Union (EU) will merely try to paper over problems and won't confront the real issues.

So what was the agenda of the tests?
The real agenda was to avoid foreign lenders to the peripheral countries taking large losses. As at June 2009, Greece owed $276 billion to international banks, of which around $254 billion was owed to European banks with French, Swiss and German banks having significant exposures According to the Bank for International Settlements, as at the end of 2009, French banks and German banks have lent $493 billion and $465 billion respectively to Spain, Greece, Portugal and Ireland.

In aggregate, the exposure of Germany and France to troubled European countries is around $1 trillion. The real purpose of the bailout is to prepare for a possible series of sovereign debt restructurings in Europe.

There has been a trillion-dollar rescue plan for the PIGS economies in Europe. How do you see that working out?
In a striking parallel to the early stages of the global financial crisis, the reality that it is a "solvency" problem not a "liquidity" problem remains unacknowledged. Most of the countries in the firing line have unsustainable levels of debt. For example, beyond 2010, Greece needs to refinance borrowings of around 7-12% of its GDP (around euro 16 billion to euro 28 billion) each year till 2014. There are significant maturing borrowings in 2011 and 2012. Greece's total borrowing is forecast to increase to around euro 340 billion (over 150% of GDP) by 2014.

Kenneth Rogoff and Carmen Reinhart in This Time It's Different, their survey of financial crises, argue that sovereign debt above 60-90% of GDP restrains growth. Greece's interest payment now total around 5% of GDP and are scheduled to rise over 8% by GDP. Rising interest costs will only worsen this problem. High levels of sovereign debt are sustainable where three conditions are met.

Firstly, the debt is denominated in its own currency. It is helpful if the currency is also a major reserve currency, an advantage enjoyed by the US dollar. Secondly, there is a large domestic saving pool to finance the borrowing, such as exists in Japan. Finally, the country possesses a sound, sustainable industrial base and there is economic growth. Greece does not meet any of the above criteria. 

The cure may not be feasible or will not help make it easier to meet future debt obligations. As historian Arnold Toynbee observed: "An autopsy of history would show that all great nations commit suicide."

How do you see the future of euro?
The euro, to paraphrase Oscar Wilde, has no enemies, but is intensely disliked by its friends. Investors assumed that the euro would be a new Deutschemark, supported by German commitment to fiscal and monetary rectitude avoiding Gallic and Mediterranean extravagance. Instead, investors are left holding a currency underpinned by unexpected German extravagance and Gallic and Mediterranean rectitude. Traders now refer to the euro as the "Drachmark" (a derisory amalgam of the former Greek Drachma and German Deutschemark). 

A Greek default via re-denomination of its debt into the new drachma would not affect the euro per se. Argentina and a whole host of emerging market nations defaulted on dollar debt with no impact of the currency itself. The real problem with the euro is the weaknesses of the Euro zone economies and the political will to implement required policies. Attempts by the Spanish government to implement a euro 15 billion austerity package was only passed by a margin of a single vote, aided by crucial abstentions. On any reasonable analysis, Greece and some of the other PIGS will not be able to pay down its debts and need to restructure its debt — a polite term for default.

The alternative — aggressive austerity programmes — will trap economies in self-defeating recession and deflation. Ireland has already implemented austerity measures. The government debt as a percentage of GDP has increased to 64% from 44%. The budget deficit as a percentage of GDP has doubled to 14% from 7%. The nominal GDP of the country has fallen by 18%. The plan may also make further liquidity problems inevitable.

So where do we go from here?
The onset of the global sovereign crisis marks a new dangerous phase of the credit crisis. At best a withdrawal of government support (through lower spending and higher taxes) will reduce global demand and usher in a potentially prolonged period of stagnation. At worst, increasing difficulty in sovereigns raising money and a clutch of sovereign debt rescheduling may result in a sharp deterioration in financial and economic conditions. There is no political will to tackle deep-seated problems. The electorate is unwilling to accept the adjustments and lower living standards that will be necessary. As the credit crisis enters a third year, the scale of sovereign debts means that governments now have limited room to counter any new economic downturn, any new problems or crisis.

Until early 2010, markets were Dancing in the Streets. Increasingly, another Holland-Dozier-Holland standard, also made famous by Martha and the Vandellas, is relevant: "Nowhere to run to, baby/ Nowhere to hide."