Last Sunday, in Is China Trying to Break the Euro?, I wrote about a glaring problem in the Eurozone; it's non-unified debt markets. At that time I highlighted articles by both George Soros and John Mauldin related to monetary policy weaknesses within the EU, then created a theory about how the Euro might be broken if these weaknesses were not readily addressed. (I'd encourage you to read the theory in its entirety from the link above but...) In summary I touched briefly on how an "entity," (possibly China) if it were powerful enough, (from a fiscal standpoint) may be able to unravel the Euro, and potentially shatter the European Union.
Within the original piece I wrote:
"[In the context of shorting the debt of the weakest Nations in the EU]...you can already see the staggering difference in debt spreads between Germany (arguably the strongest Euro zone member) and Italy, Spain, Greece, and Portugal (as above arguably the weakest). Increasing the borrowing cost on debt in the weakest countries would require capital infusions from the Central Bank, however the bank would be powerless to stop the pressure on the sovereign debt of the individual countries because, as Soros said, there is no unified European Bond Market.
After pushing borrowing costs upward in the weaker countries of the Union one would then begin shorting the Euro currency with as much cash as they possibly could. By doing this you would be adding additional downside pressure to the Euro, as the ECB in an effort to save the ailing countries you were shorting debt on, would have to be injecting more and more capital to keep them afloat. This would squeeze the entire Euro zone and, in my opinion, the strongest of the countries would begin to say "enough is enough." At which point nationalism would grow stronger, more thought would be given to the facts in Tables 1 and 2 above, and I would speculate some members would consider leaving or not assisting their ailing neighbors.
In either scenario you would be able to create a massive crisis and downside pressure on the Euro would grow significantly. Currently tensions are already high around the world as the economic crisis continues to unfold and many are starting to wonder about Europe's exposure to countries in the old soviet block which is already damaging the Euro's strength....
Before continuing I want to make it very clear that it isn't good to see the world falling apart; I do not cherish this. As much as I believe it probable and feel it may happen, I truly do not want to see the Eurozone collapse. If the Euro were to disappear, much of the world would be thrown into even more chaos than it is already in, and none of us (except maybe countries grasping for power) need that.
However, in the pursuit of truth, we must continue to search for support of my theory lest I be called an absolute quack. So as today's news began to hit the wire a report came up regarding the EU spurning calls for Eastern European Aid which I find intriguing.
From Bloomberg:
"European Union leaders spurned pleas for special aid for eastern Europe and a rescue package for automakers, bowing to German concerns over budget deficits as the economic crisis escalates. EU leaders vetoed an appeal by Hungary for loans of 180 billion euros ($228 billion) for ex-communist economies in eastern Europe...
...The worst economic slump since World War II is devastating eastern Europe, putting at risk EU goals of stitching together a continent-wide free market. The euro fell to a one-week low of $1.2562, and traded at $1.2575 as of 12:40 p.m. in Tokyo from $1.2669 late in New York on Feb. 27...
...Nine eastern leaders met before the summit to warn the West against putting up new walls in Europe, five years after the EU overcame historic divisions by admitting its first eastern members...[Angela Merkel -German Chancellor] Merkel, representing the biggest contributor to the EU budget, said aid for eastern Europe needs to be channeled through institutions like the International Monetary Fund...
...The aid plea by Hungary, already the recipient of 6.5 billion euros in EU support, also sowed divisions among eastern leaders, with some saying the EU’s newcomers shouldn't be singled out as an economic trouble spot...There are differences between eastern European countries,” Polish Prime Minister Donald Tusk said. “In some respects, western countries are in a more difficult situation...”
...French President, Nicolas Sarkozy, triggered the east-west clash by saying on Feb. 5 that it “isn’t justified” for recession-hit French car makers to operate plants in places like the Czech Republic instead of creating jobs at home. That broadside led Czech Prime Minister, Mirek Topolanek, the first head of an ex-Soviet bloc state to hold the EU presidency, to convene the summit to demonstrate European unity against protectionism"...
This is troubling because you'll note from above, one of the results of my theory was that the strongest countries within the EU would begin to become nationalistic and stand boldly against helping their neighbors. Indeed this is now occurring as both France and Germany are speaking out against assistance to Hungary, Latvia, the Czech Republic, and the other ex-soviet bloc states. In fact, the statements from France and Germany have been so strong that the Czech Republic has publicly called for a summit to discuss European unity against protectionism. This is not a small statement especially when you consider that one of the nations accused of being nationalistic, France, currently holds the presidency of the EU.
If this is happening now against the Eastern European nations, who are not on the Euro, (but are trade members of the EU) it is merely a prequel to what will occur within countries who are on the Euro. More importantly though, if the results of the theory are showing up in the relationships between the old Soviet Bloc EU and the Eurozone EU, (one could easily argue they are unified but divided) what were the symptoms? Were the conditions that I included in my original writing present prior to getting to the final results? I think they were and I'd like to share some of the reasons why I feel that way.
Although borrowing costs for most nations have been escalating for some time now, in the last two weeks credit default swap ("CDS") spreads on much of the sovereign debt within the Nations of the old Soviet Bloc have exploded. After this, ratings on debt for these countries went to near junk, and yields (read: government borrowing costs) went to the moon. As a result floating new bonds became an almost impossible option for these nations, they then had limited available operating cash flow, and have now been forced to come to the rest of Europe for aid. (As I pointed out before not unlike what is happening in California)
Remembering the stats from my first article regarding the debt spreads of Greece, Italy, Spain, and Portugal, relative to Germany, we know that this same process is occurring within the weaker countries using the Euro currency. Will their individual debt spreads get high enough over the "stable" countries of the Eurozone to rate their bonds as junk as well? Only time will tell, but judging by the severity of this recession I'd bet they'll receive a junk rating sooner rather than later. As I watch what's happening in Hungary and the Czech Republic, I can't help but wonder how on earth a country like Greece will be able to hold it together.
Also from December 17th, 2008 through tonight (March 1, 2009) the Euro has crashed down from 1.4349 to 1.2581 against the Dollar. This coincides with the bulk of the run up in debt cost to the Eastern European nations now struggling to survive. At the open of the Asian markets this evening, the Euro gaped down about 1.5 cents. This reportedly has occurred because the world is worried about the amount of exposure Eurozone banks will have to the near certain collapse of at least a few Eastern European nations. What will the market think if some of the Euro using countries start to go bust? What kind of pressure will the Euro be under then if it is under this kind of pressure now? Again, time will tell, but I would suggest we watch this week to see what the Euro/US dollar pair does during the Asian market hours. More selling during the Asian trading period may suggest that there is potentially more to China's influence on the pricing of the Euro relative to my theory.
Lastly, Asia (primarily China) has continued to fund American Debt Auctions and has readily assisted in helping to buy up all available treasuries offered. Yields on US debt continued to fall until last week, when they rose for the first time in 10 auctions. Of course the appetite for US debt has waned slightly as more and more issues have come to market, however the US treasury department is still easily able to unload it's debt onto the free market at unreasonably low rates. Moreover, seeing as Europe has no unified debt market, the security of US backed debt is nearly unrivaled in the world. As a result, I doubt very highly, regardless of what spending occurs within the USA, that anyone buying treasuries for financial security will run out on the US anytime soon. China certainly won't do that as it is continuing to build it's long "USA" position and is benefiting substantially from the run up in Dollar value within it's reserves.
In Summary
I must admit that in my first writing I considered only the countries using the Euro to be a threat to the security of the currency. In thinking this I had not fully considered the implications of the failure of Eastern European non-euro using members; That is, relative to the general viability of the Euro currency. I did however evaluate the exposure of European banks to these countries, but not what the total collapse of the financial systems would actually mean and could potentially symbolize within the theory.
That being said, in hindsight my error in judgement has revealed to me something that I think is even more troubling than China potentially targeting the weaker Euro using states. China may have intentionally contributed to the fall of the weaker non-Euro using nations first to further solidify its efforts in accomplishing it's goal of breaking the Euro.
It makes sense doesn't it? Let me explain. If you assume what I wrote originally:
"...China could benefit from this strategy significantly because it has the largest cash reserve of US dollars in the world. Since China holds between $1 and $2 trillion dollars worth of US currency it has more than enough money to start picking off the weakest of the Euro zone countries and to begin the execution of my plan above. In doing this China would be able to profit from it's shorts on the sovereign debt as the nations it targeted began to fall. Then it would also profit on it's shorts against the Euro because the Chinese are impossibly long US Dollars. Additionally, if China was able to succeed the strongest states of the Union would end up standing on their own and allowing the weaker countries to go it alone and most likely fail.
If China could accomplish this it would ultimately gain the global financial political clout it is so desperately seeking, and wouldn't have to go to war to obtain it...."
With most political, financial, or business decisions the rule of thumb is that it is prudent to take small steps before going all in. Here the small step may be China going after non-euro using EU members before going after the stronger Euro using nations. The signs are all there; heavy buying of more and more dollars, a collapse in Euro pricing, an advance in the dollar, the explosion of sovereign debt spreads in these countries, and the resulting nationalistic comments coming from the strongest members of the EU.
The only difference here to my theory is that the move was done outside the Eurozone; well kind of. China could have assisted here to "test the waters" and see how the rest of Europe would react. If this is the case, which I believe it to be, this choice may have been a brilliant one. It is brilliant because the collapse of any EU state, regardless of it's use of the Euro, will undoubtedly help China to obtain its overall goal of breaking the Euro by increasing stress within the region. But most importantly, while dealing with a finite resource in US Dollar holdings, breaking Eastern Europe first offers China more bang for it's buck, no pun intended.
Although I have been recently criticized, I will continue to stand by my opinion, unpopular as it may be. I think China is trying to break the Euro and I think they stand to gain tremendously if the region falls apart. If my theory holds look for some serious stress to begin appearing in the weaker Euro nations. By serious I mean CDS spreads sky rocketing as they did in Eastern Europe, not just being elevated as they already are. Also start to look to the currency markets for powerful moves during the Asian trading period. But most importantly watch the Treasury auctions in the US. If China continues to purchase US debt and grow its long positions even further it will have officially picked a side and will have no choice but to stand by it's $2 Trillion USD long position.
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