Why The European Bailout Is Just Postponing The Inevitable

by on May 13, 2010 | Updated July 29, 2010 | ETFs Mentioned:

Earlier this week, European leaders announced a nearly $1 trillion rescue plan to potentially bail out highly indebted EU countries. Markets initially cheered the news, with Spanish and Italian markets leading the way; the iShares MSCI Spain Index Fund (EWP) soared higher by more than 14% on the news while the iShares MSCI Italy Index Fund (EWI) jumped close to 12%. While the details of the bailout are still being determined this much is known; there will be up to $560 billion in loans from euro zone governments, $77 billion from a European Union loan fund and an expected IMF contribution of close to $320 billion. Additionally, the European Central Bank (ECB) announced that it would buy government and private debt securities in euro countries if deemed necessary.

However, now that the euphoria has worn-off, many investors are beginning to see that questions still remain over the future of the euro and that this unprecedented plan has done nothing to alleviate the three main concerns that are currently plaguing not only Greece but the other struggling nations of the euro zone as well. All Europe has managed to do with this plan is to kick the can further down the road in hopes that the mounting issues will somehow dissolve. Unfortunately, time won’t heal all wounds, and the euro zone is in for a long, hard road as the age of austerity begins (see Six ETFs To Watch As Greek Drama Unfolds). In the current environment, there are three significant hurdles to European growth:

1. No Growth

The main problem in Europe today is the lack of growth, both economically and demographically. Economic growth would make debts easier to repay since the economy and tax base would grow larger, thereby providing the government with a larger amount of money that could be used to pay down the deficit. However, Greece’s economy is expected to shrink by 3% this year and fall by a further 0.5% in 2011–not exactly prime conditions for paying back mountains of debt.

Furthermore, while lack of demographic growth isn’t always a problem, it is when a country allocates large amounts of resources to social welfare programs that require a steady supply of new workers to pay for older, retired workers’ health care and pensions. The average age for a person in Greece is 41.8 years, while close to 20% of the population is over 65 years old. Additionally, the population growth rate is just 0.127% ranking the country 188 out of 233, according to the CIA World Factbook. These figures suggest that a larger, aging population will have to be supported by fewer workers, a situation that is likely to further strain the country’s budget in the years ahead. This situation is also likely to repeat itself in Italy and have negative effects on that country’s economy. “One in five Italians is a pensioner and by 2024 the country is projected to have a million over the age of 90,” writes Guy Dinmore. “The birth rate is the third lowest in the world. By 2030 Italy’s workforce will be 16% smaller than it was in 2005.”

The bailout plan does nothing to address this demographic time-bomb that is threatening to explode in the form of higher, unsustainable pension levels across much of Europe. Furthermore, the plan does not help spur growth, it merely allows governments to roughly maintain their deficits and pay lower rates. So it’s hard to see how this program will increase economic activity in the region, a key component to paying off large amounts of debt.

2. High Deficits Will Continue

Some believe that the current bailout will buy governments time to restructure their debt and get the deficit down to a more manageable level. But this may be overly optimistic reasoning. “Greece’s current deficit is 14% of GDP,” writes Derek Thompson. “Interest payment on the debt make up about 6% of GDP. So even if Greece restructures to pay 50 cents on the dollar, slashing its interest burden in half, they’re still left with a deficit equal to (14 – [6/2] =) 11% of GDP. That’s an enormous deficit! Write down the debt by 2/3rds, and you’ve still got a budget deficit equal to 10%.” This translates into a deficit of close to $170,000 per Greek household, clearly an unsustainable number by any estimation.

While the situation isn’t quite as bad in Spain, it’s a similar problem. Many believe that the European bailout will be able to backup Spanish debt for at least the next several years. However, eventually the money will run out and it appears unlikely that Spain will find itself in a better situation in the near future. Others have noted the moral hazard element of the latest round of bailouts; these programs encourage governments to continue their spendthrift ways, only making minimal cuts in order to appease the other European nations.

Spain has taken the first steps towards implementing tough austerity measures. What remains to be seen, however, is how proposals being tossed around Madrid will translate to the bottom line. “The plan buys time, removes the threat of an immediate funding crisis, but does not alter the macro-economic fundamentals at the heart of the problem,” said Paul Marson, chief investment officer of Lombard Odier Private Bank to BusinessWeek. Marson went on to note that the bailout plan is “rather like buying a drunk another drink so that he may defer the hangover.”

3. Loss Of ECB Independence = Loss Of Confidence In Euro

Theoretically, the primary objective of the European Central Bank is to “maintain price stability” in the region. It will now be very hard for investors to believe that objective in the wake of the trillion dollar plan. After ECB president Trichet said last Thursday that the council did not discuss the option of buying government bonds further, he reversed the bank’s position when the most recent details were announced. “The chronology of last week’s events suggests that EU leaders and perhaps expressions of concern from U.S. monetary authorities played a significant role in changing his mind,” writes Paul Taylor.

It is important to remember that independence is a key issue for central banks; if it is compromised, the effects on economies can be devastating. Some worry that the ECB’s new policy of buying bonds will only have the effect of evening out the rates paid by euro zone nations;  countries like Greece and Spain will see rates fall while richer nations such as France and Germany will see rates rise to compensate investors who believe that the currency is likely to experience inflation in the near future.

While the program is likely to have a positive short-term effect in the bond markets, it could doom the euro zone currency. While the issues in the European bond market are dwarfed by the bailout package, some estimate that nearly $2 trillion trades hands every day in foreign exchange markets, suggesting that the ECB will be able to do little to stem the tide to the downside should the market pull the euro lower. Despite a brief surge on Monday following the news, the CurrencyShares Euro Trust (FXE) has fallen sharply in recent sessions. FXE has posted a loss of more than 10% so far this year and a loss of close to 4% over the past week. This trend looks likely to continue if more investors believe that the independence of the ECB has been compromised or if the plan fails in stemming the leaky European budgets (see Three ETF Plays For Euro/Dollar Parity).

The Winners

So who are the winners from this whole mess? We see a few emerging from the turmoil:

U.S. Dollar

As investors lose more confidence in the euro, they will undoubtedly flee to the relative safety of the U.S. dollar. An easy way to play this trend is with the PowerShares DB USD Index Bullish Fund (UUP). The fund allocates just more than half of its exposure to futures contracts that are short the euro and long the U.S. dollar. The fund has performed very well as of late, posting a 7.2% return this year and a 4.9% return over the past month (see more fundamentals of UUP).


Despite calls for Germany to exit the euro zone and return to the Deutschmark, the scenario remains unlikely given the huge benefit that a weak euro gives German exporters. Germany, one of the largest exporters in the world, would be struggling with an increasingly overpriced currency had it left the euro zone. However, the country benefits from the weak economies of its Southern neighbors who help to keep the exchange rates down and maintain German export competitiveness. For investors seeking exposure to the German equity market, the iShares MSCI Germany Index Fund (EWG) offers a compelling choice. The fund is heavy in industrial materials (22.6%) and consumer goods firms (14.3%) which are likely to benefit from a weaker euro which will most likely result from this bailout program (see more fundamentals of EWG).

European Financials

All this bailout really does is to provide a backstop for European banking institutions should the worse come to pass in Greece or any other country. This is because the bailout prevents the nations from defaulting on their debt and thus stops European banks from having to make massive write-downs in connection with a default disaster. “Creditors no doubt love that governments have guaranteed their high-yield loans to Greece, Portugal, Spain and any other profligate government that comes under bond-market siege,” writes the Wall Street Journal. “What investor doesn’t like a risk-free loan that pays 9%?”

For investors seeking a targeted play on these ‘risk-free’ loans, MSCI Europe Financials Sector Index Fund (EUFN) is an interesting choice. The fund soared higher on the news of the bailout by more than 10% on Monday. Although the fund is still down for the year (-9%) it could see a turnaround if it is able to extract high rates from European governments with minimal default risk (see Checking In On Six ETFs Touched By Chaos In Greece).

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Disclosure: No positions at time of writing.