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    Sense Over Sensibility In Europe…Not.

    By

    June 8, 2015

    We all hear, now on almost a daily basis about the Eurozone crisis, ever intensifying, with more and more countries living out of their means, populist measures being doled out to still stay in power, austerity and sanctions, Germany trying to bail the currency out with ECB. And yeah, not to mention government bonds in debt-stricken countries!

    Greece has those inflation-indexed and growth-linked as its only hope, right! And Portugal, if not for these bonds, would have defaulted much before Greece, and of course, we have FC Porto there, churning in the transfer window money (sell Jackson Martinez already, to Chelsea of course, though Arsenal looks tantalizingly close ).

    But if you look closer, really closer, it tells you that when Europe and dealing in Euros, sensation prevails more over sense. Emotions, over rationale.

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    DATALAB

    If you look at the average rate of returns, on a per year basis, for all Eurozone economies, it is Greece and Cyprus offering the highest rate of interests. And not just highest, the margin of difference is way too much now. And this trend is not limited to only Greece and Cyprus, the third, fourth and fifth spot on this list is taken by Portugal, Slovenia and Italy respectively, again countries which have been hit severely by the ongoing Eurozone crisis. To further validate this fact, if we look at the correlation between credit rating (Source: Trading Economies) and interest rates have a High Negative Correlation of -0.93444. This means that, lower the credit rating, higher the interest rate to be paid on sovereign bonds.

    RATIONALIZING THE PHENOMENON

    While these are often used as a measure to control inflation, at a time when these countries are severely cash-strapped, these high interest rates serve a double purpose in getting the Central Banks the much needed cash to recapitalize private banks and get on with the public spending (Yes, I am a big fan of Public Expenditure to revive economy).

    So, as common rationality prevails, if the reward justifies the risk, funds should flow into these countries.

    This is where the conservatism of the more affluent European nations becomes the root cause of its own problems.

    If you look at the deposits made by German Nationals in past two years, about 55% of their total GDP gets deposited back in German banks only. German banks, which offer the lowest term-deposit rate as well as the Sovereign Bond yields out of all Euro zone economies. At this time, it becomes again very important to state that average yield on 5-year term deposits bears a +0.893 correlation with the Sovereign Bond Yields.

    But isn’t it more rational on part of Europeans to prefer Safety over Returns?

    Well, there are multiple perspectives on that, and only time will tell which one prevails.

    1. My Money, I want Safety.

    This seems to be the common rationality prevailing in Europe. Since Credit Ratings bear such a high negative correlation with Bond Yields, this means only countries which are not doing so well (Greece, Cyprus, Italy, Portugal; GCIP for further reference) are offering these rates as a bait. Now the catch to this bait being, if these countries default, our money drowns.

    Now it is in this regard, I find all these concerns to be stepping out of sentiment than pragmatism. Firstly, countries don’t just default. Even Greece, despite everyday news and Varoufanikis’ own admissions, didn’t default on its bonds. Its still paying those interest, irrespective of the money flow it has. That is the beauty of having coupon rates, right? If a bond pays 5% interest per year, with a statutory margin of 10% (say; its much higher in reality), the government will not default on my bonds for at most 17 next years.

    But even if the government goes ahead and spends a part of it, dispensing it to the public in form of Pensions and other dole outs (more probable scenario), common sense should dictate that in the absence of Private Investment by Institutional investors (who will stay away from GCIP, irrespective of anything) , it is only the public spending that would trigger a revival in these economies. More money, equals more expenditure, which equals more production, which equals more employment, leading to more taxes (Yayy).

    Now ironically, this aversion to risk is what is increasing the exposure to risk even further. As Euro fears a Grexit, and now increasingly, a Brexit, the ECB would do anything and everything to prevent this, like it has been doing. And this Tsipras government seems to have caught on this view. SO on one hand, risk is rising, on the other, growth won’t pick up because of the perceived risk aversion!

    1. History and Love.

    Europe has been a continent with a rich, vast history. It has had its Wars, it has seen the rise and fall of civilizations and monarchs( from Ancient Greece and Rome, to Meet the Spartans), it has had its dictators ( and not Admiral General Aladeen), to economic systems that changed the world. Somewhere lying as a function of all this, and much more complicated factors, is the investment sentiment in Europe.

    For instance, Poland has a higher credit rating (for those risk averse people) and almost the equal interest rates and YTM on bonds as compared to Italy, but the rich European trio, Britain, France and Germany, still prefers Italy over Poland. Rationalizing this has become a problem for policy makers and economists alike, but history fills in the gaps. Equilibrium changed after the Second World war in Europe, and Italy and Germany, despite being on the opposite Axis (Pun intended), were welcomed back. And hey, USSR was not. Hence, Poland is still seen with an eye of suspicion because of its Communist past. And similar is the case with the Eastern European Bloc, which has had a much better economic health than at least the GCIP.

    So the argument to such racism, which is often left untouched by UEFA, has been the unwillingness of the retail investor in foreign markets, generally. A look at facts proves this to be untrue. Portugal is as foreign as Poland, with the same rules and procedures. Even more startling is the fact that the Russia, an altogether different country, with a different currency, dwindling over the past few months, has more retail investors from Europe than the said Eastern Bloc.

    All said and done, a little investor education in simple economic logic, a medium term sustained support to falling economies, and an end to financial racism, Euro could be back on track, and somewhat stronger too.

    Views presented in the article are those of the author and not of ED.

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