When you bum rides off other people, you don’t have the luxury of telling them how to drive or which route to take.
The same could be said about the current crisis in Europe, where escalating debt levels have plagued Greece and put a squeeze on the rest of the 17-member euro zone. This economic duress has put Germany in the driver’s seat. It’s the only country in the currency union with the financial wherewithal to subsidize its cash-strapped neighbors and still achieve growth. However, in exchange for giving their neighbors a lift and the fiscal hit it’s taking, Germany is likely to take the wheel in deciding policy.
It evokes an all-important question: Would it really damage the euro zone’s fiscal health if Greece’s economy sank into the Mediterranean? Probably not. But what matters is who holds Greece’s debt. They want to be made whole.
Imagine for a minute that Germany owned all of Greece’s sovereign debt. Picture Chancellor Angela Merkel, not too long ago, sitting uncomfortably at the end of a long boardroom table in Berlin’s Federal Chancellery building. Surrounding her are the heads of various German financial organizations—the ones responsible for purchasing the cursed Grecian debt. They’re all shouting and pounding on the table, demanding that Merkel make the Greeks pay. They’re insisting on taxpayer bailout funds in exchange for writing down the debt. There she sits trying to assess Germany’s sovereign-debt exposure and balance-sheet strength, wondering, “How much is this going to cost my country?”
Let’s do the math: Greece makes up only a 2% slice of euro-zone gross domestic product, but its debt is 165% of GDP. Germany’s GDP is 28% of the euro-zone pie while its debt equals an estimated 80% of its GDP. Multiply 2% by 165%. Then divide by 28%. The answer? 11.7%. Germany’s debt-to-GDP has to increase by 11.7% to fully bail out Greece. While it’s no pittance, it still amounts to a manageable debt-to-GDP ratio—91.7%—among the major economies of the world.
But the reality is that Germany doesn’t own all of Greece’s debt. Banks and financial institutions in other countries own their share too. Still, Germany’s role is important. It’s the largest economy in the euro zone. And it’s not running large fiscal deficits. In fact, Germany has a trade surplus. It has the capacity to raise sovereign debt cheaply—by issuing bonds at razor-thin interest rates—and that’s exactly what it’s doing.
Breaking the Rules
Meanwhile, most of Germany’s fellow euro-zone nations fail to meet the criteria outlined in the Treaty of Maastricht, which created the European Union in 1992 and paved the way for a unified currency. It included targets for inflation, caps on budget deficits, national debt, interest rates and exchange rates. The number of countries violating the Maastricht criteria over the past three years has increased significantly—and it’s not getting any better. Indeed, 11 out of the 17 countries are not living up to the fiscal requirements and 12 countries are not adhering to the sovereign-debt parameters. Each fiscal deficit manifests itself in rising debt-to-GDP levels. If growth can exceed debt, then these countries would be making progress. But so far, it hasn’t happened.
So what is Germany’s exposure to all forms of euro-zone debt? All in, it comes to 600 billion to 700 billion euros or roughly a quarter of the country’s GDP. If this is a full-on bailout, then it pushes Germany’s debt-to-GDP ratio to 105%—similar to the United States. This is comparable to the cost of bailing out the U.S. financial sector to the tune of $1.5 trillion, roughly equal to the market capitalization of the Russell 1000 Financial Services Index at the end of 2011.
Here’s what it means for investors:
- Germany can take care of itself and can keep its financial system afloat
- Financial firms in other euro-zone countries are suspect, but the European Central Bank’s long-term refinancing options (LTRO) can subsidize them
- Germany is in the driver’s seat and will heavily influence fiscal policy decisions in the euro zone
Cutting Them Off
How long will Germany keep the party going? And how much German influence will the other euro-zone countries allow? Merkel recently said that euro-zone bonds would be “economically wrong and counterproductive” and that there will be no euro-zone bonds “for as long as I live.” How’s that for German influence?
In the end, Germany will support its own financial institutions. And it may satisfy any additional obligations through the ECB’s LTRO. It will be a drain on Germany’s resources by way of taxes, debt issuance or inflation. Essentially, it’s the ongoing cost of preserving the euro and a way to make up for losses incurred by its financial institutions as holders of sovereign debt.
But Germany appears to have little interest in guaranteeing a collective facility that enables the PIGS of the south—Portugal, Italy, Greece and Spain—to finance their indiscretions indefinitely. The higher costs of sovereign-debt issuance would force euro-zone governments to shrink, exacting a discipline upon some countries to bring their financial houses into order. This is a good thing. Going on a financial diet and trimming the size of government should make for healthier equity markets in those countries too.
Right now, Germany is financially fit enough to shoulder the load of its exposure to the PIGS. But it will expect some control over local fiscal policies in return. Given the economic revival Germany engineered after the Berlin Wall came down, it would seem logical to draft a similar approach to the euro zone’s current predicament. Consider it payback for picking up the tab.