Is the Eurozone the New Korean DMZ?

Capital cities around the world issued a sigh of relief on Friday, a reaction that the commercial cities ignored or feared. The eurozone compact, or more correctly, the belief that seventeen nations can quickly agree and execute the identical fiscal treaty, is highly questionable. If there is any real value to the agreement, hopefully it will make it easier for politicians to cudgel their people into agreeing to spending cutbacks. Only by cutting government spending and at the same time raising tax revenues can the deficits be brought down to one half of one percent of GDP.

While it may be a stretch to compare the eurozone of 17 nations to the narrow Demilitarized Zone between South and North Korea, there is much to be learned from a comparative analysis of their effectiveness. Both separations were to protect all parties from the dangers of war. In the case of the EZ, the war is fought with currencies which are based on purchasing power parity, determining the ability to export goods and services. The alternative is being forced to continue to export good jobs. Both zones have worked well for one group but not for the others. The balance is maintained by the apparent winners taking on significant defense expenditures. In the case of the EZ, the defenses will be in the form of subsidies to the slow-growing members and currency manipulation to keep the export costs low. On the one hand the EZ has the benefit of the European Central Bank (ECB), but in the end the ECB’s size could be destructive to the long-term ability to borrow money cheaply. The ECB appears to be the one organization that can issue unlimited amounts of euros. While that may help on the subsidy side, flooding the market with euros is likely to drive relative interest rates higher. Perhaps the best summary of the deal that has apparently been struck comes from Mohammed El-Erian of PIMCO Investments who wrote: “What came out is necessary, but not sufficient.” Thus the currency, bond, commodity, and stock markets are not likely to be calm.

Superior economics didn’t help

As regular readers of this weekly blog and my managed accounts have learned, I have been an advocate of increasing one’s investment in Asia. The thought process behind this move is that most of the countries in the region have young populations that want to work, are increasingly well-educated and have family savings orientations. While my thinking is long-term, some may say too long-term even for endowments, poor short-term performance is a bit upsetting. In a period of four months, a number of these good long-term investments declined some 20%, all the while growing earnings. What did I miss? I missed the inter-connected, “One World” nature of investing these days. For many Asian countries, their biggest export market is Europe, and Europe appears to be entering into a recession which may become worse under various mandated austerity programs. I understood and was somewhat prepared for this linkage. What I should have picked up was the proportion of Asian debt owned by European banks, as pointed out by a recent Matthews Asia Insight report entitled “Capital Flows: Asia’s Quiet Revolution.” European Banks own over 20% of the debt of Malaysia and Taiwan, as well as over 15% of South Korean debt. The US bank share is about 10% in South Korea and below that in all other countries in the region. Over 30% of Indonesian, and more than 20% of Malaysian debt are owned by combined foreign banks in local currency government bonds. One can assume under current conditions it is unlikely that the Europeans will be rolling over their Asian debt. Higher interest rates (lower bond prices) will be needed to attract US investors who are pouring money into the region.

What to do now

Long-term investors should continue to add selectively to their Asian holdings of companies meeting their own domestic demand. For more immediate performance-oriented accounts, try to pick up the eventual rise in Asian stocks when European banks have stopped liquidating their loans. One of the turning points to watch for is when the banks will be released from their requirements to own “riskless” government bonds. Hopefully this will be soon, but based on the agreements announced, we should not hold our breath.

Do you agree? Please let me know.
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